[Federal Register Volume 83, Number 224 (Tuesday, November 20, 2018)]
[Rules and Regulations]
[Pages 58476-58498]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-24545]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9843]
RIN 1545-BG07
Allocation of Costs Under the Simplified Methods
AGENCY: Internal Revenue Service (IRS), Treasury.
[[Page 58477]]
ACTION: Final regulations.
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SUMMARY: This document contains final regulations on allocating costs
to certain property produced or acquired for resale by a taxpayer.
These final regulations: Provide rules for the treatment of negative
adjustments related to certain costs required to be capitalized to
property produced or acquired for resale; provide a new simplified
method of accounting for determining the additional costs allocable to
property produced or acquired for resale; and redefine how certain
types of costs are categorized for purposes of the simplified methods.
These final regulations affect taxpayers that are producers or
resellers of property that are required to capitalize costs to the
property and that elect to allocate costs using a simplified method.
DATES:
Effective Date: These regulations are effective on November 20,
2018.
Applicability Date: For date of applicability, see Sec. Sec.
1.263A-1(l)(5) and 1.263A-2(g)(3).
FOR FURTHER INFORMATION CONTACT: Natasha M. Mulleneaux, of the Office
of the Associate Chief Counsel (Income Tax and Accounting) at (202)
317-7007 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
This document contains final regulations that amend the Income Tax
Regulations (26 CFR part 1) relating to allocation of costs to certain
property produced or acquired for resale under section 263A of the
Internal Revenue Code (Code).
Section 263A requires taxpayers to capitalize the direct costs and
indirect costs that are properly allocable to: (1) Real or tangible
personal property produced by the taxpayer, and (2) real and personal
property described in section 1221(a)(1) acquired for resale by the
taxpayer. The costs that a taxpayer must capitalize under section 263A
are its section 471 costs, additional section 263A costs, and interest
capitalizable under section 263A(f). Section 263A generally requires
taxpayers to allocate capitalizable section 263A costs to specific
items of property produced or acquired for resale. However, section
263A(j) instructs the Secretary to prescribe regulations that may be
necessary or appropriate to carry out the purposes of section 263A,
including regulations providing simplified procedures. Accordingly,
Sec. 1.263A-1(f)(1) allows taxpayers to use the simplified methods
provided in Sec. 1.263A-2(b) (the simplified production method (SPM))
or Sec. 1.263A-3(d) (the simplified resale method (SRM)) to allocate a
lump sum of additional section 263A costs properly allocable to
property produced or acquired for resale to property that is on hand at
the end of the taxable year, in lieu of allocating costs to specific
items of property. Some taxpayers using the SPM or SRM include a
negative adjustment in additional section 263A costs when the taxpayer
capitalizes a cost as a section 471 cost in an amount that is greater
than the amount required to be capitalized for tax purposes. Notice
2007-29 (2007-14 IRB 881) provides that, pending the issuance of
additional published guidance, the IRS generally will not challenge the
inclusion of negative adjustments in computing additional costs under
section 263A or the permissibility of aggregate negative additional
section 263A costs.
On September 5, 2012, the Treasury Department and the IRS published
in the Federal Register (77 FR 54482) a notice of proposed rulemaking
(REG-126770-06, 2012-38 IRB 347) under section 263A (the proposed
regulations) relating to the inclusion of negative adjustments in
additional section 263A costs under the simplified methods. The
proposed regulations also provided a new simplified method of
accounting, the modified simplified production method (MSPM), for
determining the additional section 263A costs allocable to property
produced or acquired for resale, and redefined how certain types of
costs are categorized for purposes of the simplified methods. Two
comments responding to the proposed regulations were received and a
public hearing was held on January 7, 2013. After consideration of the
comments received, these final regulations adopt the proposed
regulations as revised by this Treasury decision.
Summary of Comments and Explanation of Provisions
1. General Prohibition on Negative Adjustments in Additional Section
263A Costs
The proposed regulations generally provided that taxpayers could
not include negative adjustments in additional section 263A costs to
remove section 471 costs, unless the taxpayers used: (1) The SPM and
had average annual gross receipts of $10,000,000 or less; (2) the SRM;
or (3) the MSPM.
Both commenters stated that the proposed regulations' prohibition
on including negative adjustments in additional section 263A costs for
taxpayers using the SPM (and above the gross receipts threshold) was
unfair to taxpayers unable or unwilling to use the MSPM. One commenter
suggested that taxpayers using the SPM are at a disadvantage compared
to taxpayers using the MSPM, because the SPM overcapitalizes additional
section 263A costs to the raw material content of ending inventory.
Another commenter stated that the proposed regulations' prohibition on
including negative adjustments in additional section 263A costs under
the SPM unduly punished taxpayers that were unable to use the MSPM by
requiring those taxpayers to calculate the amount of deductible section
471 costs that should be excluded from ending inventory. This commenter
also suggested that only a small number of taxpayers have the resources
to determine these costs.
The Treasury Department and the IRS do not adopt these comments
because including negative adjustments in additional section 263A costs
under the SPM may result in significant distortions of the amount of
additional section 263A costs and section 471 costs allocated to ending
inventory. However, these final regulations include several changes to
address these comments and reduce compliance costs, burden, and
administrative complexity. Generally, including negative adjustments in
additional section 263A costs results in distortions because the method
used to capitalize the section 471 cost is different than the method
used to remove the cost from ending inventory. The extent of the
distortion, and whether it is favorable or unfavorable to the taxpayer,
generally depends on whether the cost was incurred in the production
process and how the cost was allocated to raw materials, work-in-
process, or finished goods inventories for purposes of section 471.
Accordingly, the general restriction on the inclusion of negative
adjustments in additional section 263A costs provided in the proposed
regulations remains unchanged in these final regulations.
In order to limit potential distortion in the simplified methods,
these final regulations also provide a new consistency requirement for
taxpayers that are permitted to include negative adjustments in
additional section 263A costs to remove section 471 costs and that
include negative adjustments to remove section 471 costs. The rule
provides that such taxpayer must use this method of accounting for all
section 471 costs that are permitted to be removed using negative
adjustments.
In addition, these final regulations clarify that certain business
expenses described in section 162(c), (e), (f), and (g), including
bribes, lobbying expenses,
[[Page 58478]]
and fines and penalties, cannot be removed from a taxpayer's section
471 costs as negative adjustments in additional section 263A costs.
This clarification is consistent with Sec. 1.471-3(f), which provides
that certain of these expenses are not permitted to be included in the
cost of inventories.
2. Classification of Costs
One commenter stated that it was unclear how negative adjustments
in additional section 263A costs are measured (for example, in the case
of depreciation, at the individual asset level or using total
depreciation expense). These final regulations provide that section 471
costs, additional section 263A costs, and any adjustments to section
471 costs or additional section 263A costs are classified using the
narrower of (1) the classifications of costs used by the taxpayer in
its financial statement or (2) the classifications of costs in Sec.
1.263A-1(e)(2), (3), and (4). If a cost is not described within Sec.
1.263A-1(e)(2), (3), or (4), the cost is classified using the
classification of costs used in the taxpayer's financial statement.
3. Modified Simplified Production Method
The proposed regulations provided a new simplified method, the
MSPM, to reduce distortions that may result from the SPM. The MSPM in
the proposed regulations reduced distortions by more precisely
allocating additional section 263A costs, including negative
adjustments, among raw materials, work-in-process, and finished goods
inventories on hand at year end. Generally, taxpayers would have
determined the allocable portion of pre-production additional section
263A costs using a pre-production absorption ratio of pre-production
additional section 263A costs incurred during the taxable year over raw
materials costs incurred during the taxable year. This ratio would have
applied to raw material section 471 costs incurred during the taxable
year and remaining on hand at year end (including unprocessed raw
materials, and raw materials integrated into work-in-process and
finished goods). Similarly, under the MSPM in the proposed regulations,
taxpayers would have determined the allocable portion of all other
additional section 263A costs using a production absorption ratio of
production additional section 263A costs incurred during the taxable
year over production section 471 costs incurred during the taxable
year. This ratio would have applied to production section 471 costs
incurred during the taxable year and remaining on hand at year end
(excluding raw materials integrated into work-in-process and finished
goods).
Both commenters stated that some taxpayers could not readily
identify raw materials that are integrated into work-in-process and
finished goods inventories on hand at year end. The commenters asserted
that those taxpayers would have to modify their books and records or
purchase a new computer system to track these raw materials. Both
commenters stated that this requirement would place an unfair burden on
taxpayers, especially smaller taxpayers. One commenter suggested that
the final regulations clarify that a taxpayer may use any reasonable
method to estimate the raw material component of work-in-process and
finished goods inventories on hand at year end.
First, to reduce the number of defined terms and to be consistent
with the use of that term in Sec. 1.263A-1(e)(2)(i)(A), these final
regulations use the term ``direct material costs'' rather than ``raw
material costs,'' as used in the proposed regulations.
Second, the Treasury Department and the IRS understand that some
taxpayers may not be able to readily identify direct material costs in
work-in-process and finished goods inventories on hand at year end.
Accordingly, these final regulations modify the MSPM so that taxpayers
using the MSPM are not required to separately track direct material
costs that are integrated into work-in-process and finished goods
inventories. Specifically, these final regulations modify the MSPM by:
(1) Applying the pre-production absorption ratio to only unprocessed
direct material section 471 costs incurred during the taxable year and
remaining on hand at year end; (2) applying the production absorption
ratio to all production section 471 costs incurred during the taxable
year and remaining on hand at year end, which includes direct material
costs that have entered or completed production; (3) including the pre-
production additional section 263A costs that are not allocated by the
pre-production absorption ratio in the numerator of the production
absorption ratio; and (4) including the direct material costs that have
entered or completed production in the denominator of the production
absorption ratio. These modifications to the proposed MSPM reduce
compliance costs, burden, and administrative complexity by eliminating
the need to separately track direct material costs in work-in-process
and finished goods inventories on hand at year end.
One commenter stated that the production absorption ratio under the
MSPM in the proposed regulations was distortive because it included
post-production additional section 263A costs (for example, storage and
handling allocable to finished goods). This commenter suggested the
MSPM include a third ratio to allocate post-production additional
section 263A costs to finished goods inventories. This suggestion is
not adopted in the final regulations because including a third ratio to
allocate post-production additional 263A costs adds a degree of
complexity to the MSPM that outweighs the benefit of the additional
precision it might provide.
4. Allocation of Mixed Service Costs Under the MSPM
The proposed regulations provided that taxpayers must allocate
capitalizable mixed service costs to pre-production additional section
263A costs in proportion to the raw material costs in total section 471
costs, with the remaining amount of capitalizable mixed service costs
allocated to production additional section 263A costs. The proposed
regulations also specifically requested comments on how mixed service
costs should be allocated between raw materials, work-in-process, and
finished goods under the MSPM.
Both commenters stated that generally raw materials do not attract
a large amount of mixed service costs, except for a limited amount of
labor-related purchasing costs. The commenters stated that the proposed
regulations' allocation of capitalizable mixed service costs between
pre-production and production additional section 263A costs resulted in
a disproportionate allocation of mixed service costs to pre-production
additional section 263A costs. One commenter suggested that the final
regulations allow taxpayers to allocate capitalizable mixed service
costs between pre-production and production additional section 263A
costs using any reasonable method and provided an example of a labor-
based allocation method to allocate mixed service costs.
In response to the comments, these final regulations expand the
types of methods permitted under the MSPM to allocate mixed service
costs between pre-production and production additional section 263A
costs. These regulations provide that a taxpayer using the MSPM that
capitalizes mixed service costs using the simplified service cost
method under Sec. 1.263A-1(h) may allocate capitalizable mixed service
costs to pre-production
[[Page 58479]]
additional section 263A costs based on unprocessed direct material
costs in section 471 costs or, alternatively, based on pre-production
labor costs in total labor costs. Additionally, if a taxpayer using the
MSPM determines its capitalizable mixed service costs using a method
described in Sec. 1.263A-1(g)(4) (a direct reallocation method, a
step-allocation method, or any other reasonable allocation method), the
taxpayer must use a reasonable method to allocate the costs (for
example, department or activity costs) between pre-production and
production additional section 263A costs, unless the taxpayer's
departments or activities are identified as exclusively pre-production
or production. For example, it may be reasonable for a taxpayer using a
method described in Sec. 1.263A-1(g)(4) to allocate a department's
mixed service costs between pre-production and production additional
section 263A costs based on labor associated with the department when
the department is not exclusively identified as pre-production or
production. If a taxpayer that determines its capitalizable mixed
service costs using a method described in Sec. 1.263A-1(g)(4) has
departments or activities that are identified as exclusively pre-
production or production, the department or activity costs must be
allocated to pre-production or production additional section 263A costs
according to the department's or activity's identification.
One commenter stated that the proposed regulations would
unnecessarily require taxpayers that do not have any additional section
263A costs that relate to raw material costs to compute a pre-
production absorption ratio. The commenter suggested allocating
capitalizable mixed service costs between pre-production and production
additional section 263A costs based on the relative proportion of
additional section 263A costs in each category that are incurred by the
taxpayer. These final regulations do not adopt this suggestion because
the relative amount of pre-production and production additional section
263A costs reflect the amount of capitalizable tax costs in excess of
the costs capitalized for financial statement purposes but do not
accurately reflect the amount of mixed service costs allocable to pre-
production and production activities. However, in response to this
comment and to reduce compliance costs and burden, these final
regulations include a de minimis rule that allows taxpayers using the
MSPM to allocate 100 percent of capitalizable mixed service costs to
pre-production or production additional section 263A costs if 90
percent or more of the mixed service costs would otherwise be allocated
to that amount.
5. Property Produced for the Taxpayer Under a Contract and Property
Acquired for Resale
The proposed regulations did not provide explicit rules for the
treatment of costs related to property produced for the taxpayer under
a contract with another party that is treated as property produced by
the taxpayer, as described in Sec. 1.263A-2(a)(1)(ii)(B) (property
produced under a contract), and property acquired for resale under the
MSPM.
One commenter suggested that all costs related to property produced
under a contract and property acquired for resale should be included in
the pre-production absorption ratio under the MSPM. The Treasury
Department and the IRS agree that generally costs related to property
produced under a contract and property acquired for resale are best
treated as pre-production costs because costs related to such property
are primarily purchasing, storage, and handling costs, which are the
costs frequently attributable to property that has not entered
production. Accordingly, these final regulations adopt this suggestion
and provide that additional section 263A costs properly allocable to
property produced under a contract and property acquired for resale are
generally included in pre-production additional section 263A costs
under the MSPM. Similarly, section 471 costs for property produced
under a contract and property acquired for resale are generally
included in pre-production section 471 costs under the MSPM.
One commenter also suggested that the final regulations clarify the
treatment of costs related to property produced under a contract when
the property is used in an additional production activity of the
taxpayer. These final regulations adopt this suggestion and clarify
that for purposes of the MSPM, direct material costs include property
produced under a contract that are direct material costs for the
taxpayer to be used in an additional production process of the
taxpayer. These costs are included in pre-production section 471 costs.
6. Last-In, First-Out (LIFO) Method Taxpayers Using the MSPM
The proposed regulations provided that LIFO method taxpayers using
the MSPM must multiply an inventory increment by a combined absorption
ratio to determine the amount of additional section 263A costs that
must be added to the taxpayers' increment for the year. The proposed
regulations defined the numerator of the combined absorption ratio as
total additional section 263A costs allocable to eligible property
remaining on hand at year end and the denominator as the total section
471 costs remaining on hand at year end. The proposed regulations also
specifically requested comments on how the MSPM should apply to
taxpayers using the LIFO method.
One commenter suggested that LIFO-method taxpayers should be
allowed to use the same two absorption ratios as taxpayers using the
first-in, first-out (FIFO) method of accounting for inventories, rather
than a combined absorption ratio, to determine the amount of additional
section 263A costs that must be added to the inventory increment for
the year. This suggestion is not adopted because it would require LIFO-
method taxpayers to divide their inventory increments and decrements
into raw material and production components, which would add
unnecessary complexity and administrability challenges to the LIFO
method and the MSPM.
One commenter suggested that LIFO-method taxpayers should be
allowed to choose between annual absorption ratios and shorter-term
ratios, and base the shorter-term ratios on the taxpayer's method of
determining the current-year cost of the items in ending inventory and
the value of any inventory increments. This suggestion is not adopted
because it ignores the fact that indirect costs are frequently incurred
outside of the period used for determining current-year cost, and use
of a shorter-term ratio could cause distortions.
One commenter suggested that the final regulations provide special
rules for taxpayers that have elected to apply the LIFO method only to
raw materials, including raw materials that have entered or completed
the production process (the raw material content LIFO method).
Specifically, the commenter suggested that final regulations provide
that the combined absorption ratio should be applied to any LIFO
increment of a taxpayer using the raw material content LIFO method with
the pre-production and production absorption ratios applied separately
to non-LIFO inventory. The Treasury Department and the IRS agree that
the combined, pre-production, and production absorption ratios could
all apply in the case of a taxpayer using the raw material content LIFO
method and believe this point is sufficiently clear in these final
regulations.
[[Page 58480]]
One commenter stated that the definition of the combined absorption
ratio was ambiguous because it did not indicate whether the combined
absorption ratio was determined on a LIFO basis. The Treasury
Department and the IRS intended that the combined absorption ratio be
determined on a non-LIFO basis; accordingly, this point is clarified in
these final regulations.
7. Definition of Section 471 Costs
The proposed regulations provided one definition of section 471
costs that applied to taxpayers using the SRM, SPM, or MSPM, regardless
of whether those taxpayers were in existence before the effective date
of section 263A. The proposed regulations generally provided that a
taxpayer's section 471 costs were the costs, other than interest, that
the taxpayer capitalized to its inventory or other eligible property in
its financial statements. The proposed regulations also provided,
consistent with the IRS's established administrative practice, that
taxpayers must include all direct costs in section 471 costs regardless
of the treatment of the costs in their financial statements.
These final regulations clarify that a taxpayer's section 471 costs
are the types of costs capitalized to property produced or property
acquired for resale in the taxpayer's financial statement. These final
regulations also clarify that a taxpayer determines the amounts of its
section 471 costs by using the amounts of those costs that are incurred
in the taxable year for federal income tax purposes. These final
regulations also generally retain the proposed regulations' requirement
that section 471 costs must include all direct costs of property
produced and property acquired for resale.
However, the Treasury Department and the IRS understand that
maintaining separate financial statement and federal income tax cost
accounting systems or adjusting the amounts of costs capitalized using
the taxpayer's financial statement methods for federal income tax
purposes can be costly and burdensome. Therefore, these final
regulations provide an alternative method that certain taxpayers may
use to determine the amounts of their section 471 costs. This
alternative method is available to a taxpayer that is permitted to
include negative adjustments in additional section 263A costs to remove
section 471 costs if that taxpayer's financial statement is described
in Sec. 1.263A-1(d)(6)(i), (ii), or (iii) (for example, a financial
statement required to be filed with the Securities and Exchange
Commission (SEC); a certified audited financial statement used for a
substantial non-tax purpose; or a financial statement (other than a tax
return) required to be provided to the government). This method is not
available to a taxpayer if the taxpayer's financial statement is
described only in Sec. 1.263A-1(d)(6)(iv) (for example, an unaudited
financial statement used for a substantial non-tax purpose). The use of
this alternative method is limited to taxpayers that have certain
financial statements in order to provide adequate safeguards for the
use of financial statement amounts in the simplified method formulas. A
taxpayer that uses the alternative method determines the amounts of all
of its section 471 costs by using the amounts of costs capitalized to
property produced or property acquired for resale in the taxpayer's
financial statement using the taxpayer's financial statement methods of
accounting. A taxpayer using the alternative method may not include any
financial statement write-downs, reserves, or other financial statement
valuation adjustments when determining the amounts of its section 471
costs.
In order to limit potential distortions in the simplified methods'
absorption ratios, these final regulations require a taxpayer that uses
the alternative method to consistently apply the method to all of its
section 471 costs, including any direct costs required to be included
in section 471 costs, any costs used for purposes of applying the de
minimis direct costs rules, any costs included in additional section
263A costs after applying the de minimis direct costs rules and the
safe harbor rule for certain variances and under or over-applied
burdens, and any costs removed from section 471 costs because such
costs are not required to be, or are not permitted to be, capitalized
under section 263A. In addition, a taxpayer using the alternative
method includes in additional section 263A costs all negative
adjustments to remove section 471 costs and all permitted positive and
negative book-to-tax adjustments. A taxpayer using the alternative
method, and the burden rate or standard cost methods described in Sec.
1.263A-1(f)(3), determines the book-to-tax adjustments required to be
made as a result of differences in financial statement and tax amounts
by comparing the actual amount of the cost incurred in the taxable year
for federal income tax purposes to the actual amount of the cost
incurred in the taxable year in its financial statement using the
taxpayer's financial statement methods of accounting, regardless of how
the taxpayer treats its variances or under or over-applied burdens.
One commenter noted that the proposed regulations do not specify
how taxpayers must account for differences between their financial
statement methods and the tax methods used to determine the value of
ending inventory. These differences include special tax methods, such
as the lower of cost or market method and the retail inventory method,
as well as special financial statement methods, such as write-downs or
reserves for slow-moving goods. The final regulations do not change the
current requirement that a taxpayer must value its ending inventory by
applying its tax methods of accounting, and provide that a taxpayer
using the alternative method to determine the amounts of its section
471 costs may not include any financial statement write-downs,
reserves, or other financial statement valuation adjustments when
determining the amounts of its section 471 costs.
8. Financial Statement Hierarchy and Recordkeeping Requirements for
Financial Statements
The proposed regulations did not provide any guidance as to which
financial statement a taxpayer uses to determine its section 471 costs.
For clarity and consistency, these final regulations provide that for
purposes of section 263A, a taxpayer's financial statement is its
financial statement of the highest priority, in accordance with the
list of categories of financial statements, in order of priority,
provided in these final regulations. For example, in order to determine
its types of section 471 costs, a taxpayer uses the types of costs
capitalized in its financial statement with the highest priority within
the categories described in these final regulations.
These final regulations do not impose any specific record keeping
requirements for a taxpayer's identification of costs as section 471 or
additional section 263A costs, or for a taxpayer's determination of the
amounts of section 471 costs. However, the regulations under section
6001 require a taxpayer to keep books and records sufficient to
establish the amount of gross income, deductions, credits, or other
matters required to be shown in an income tax return, which includes
the identification of costs as section 471 or additional section 263A
costs and the determination of the amounts of section 471 costs. This
requirement also includes any books and records sufficient to establish
a taxpayer's calculation of variances and under or over-applied burdens
used for financial statement purposes.
[[Page 58481]]
9. De Minimis Exceptions for Certain Direct Costs in Section 471 Costs
a. Direct Labor Costs
As noted previously, the proposed regulations provided, consistent
with the IRS's established administrative practice, that taxpayers must
include all direct costs in section 471 costs regardless of the
treatment of the costs in their financial statement. Both commenters
stated that some taxpayers do not capitalize certain direct labor costs
(for example, holiday pay, sick leave pay, shift differential, and
payroll taxes) to inventory for financial statement purposes, and that
the proposed regulations' requirement to include all direct costs in
section 471 costs would force these taxpayers to create or purchase and
maintain a second inventory costing system for tax purposes only.
These final regulations generally retain the proposed regulations'
requirement that section 471 costs must include all direct costs of
property produced and property acquired for resale. However, to reduce
compliance costs, burden, and administrative complexity, these final
regulations provide a de minimis direct labor costs rule to allow
taxpayers using the SRM, SPM, or MSPM to include in additional section
263A costs, and exclude from section 471 costs, certain direct labor
costs that are not capitalized to property produced or property
acquired for resale in the taxpayer's financial statement
(uncapitalized direct labor costs). However, a taxpayer cannot use this
de minimis direct labor costs rule to include in additional section
263A costs basic compensation or overtime or the types of costs
included in the taxpayer's standard cost or burden rate methods used
for section 471 costs.
Under this de minimis direct labor costs rule, a taxpayer includes
in additional section 263A costs, and excludes from section 471 costs,
the total amount of all direct labor costs that are incurred in the
taxable year that are uncapitalized direct labor costs, if the total
amount of those costs is less than five percent of total direct labor
costs incurred in the taxable year (whether or not capitalized for
financial statement purposes). The de minimis direct labor costs rule
requires that any amounts that constitute a reduction to costs be
treated as positive amounts for purposes of determining whether the
taxpayer's uncapitalized direct labor costs meet the five percent test.
For a taxpayer using the alternative method to determine the amounts of
its section 471 costs, the five percent test and the amount included in
additional section 263A costs are based on the amount of uncapitalized
direct labor costs and total direct labor costs that are incurred in
the taxable year in the taxpayer's financial statement using the
taxpayer's financial statement methods of accounting. The alternative-
method taxpayer includes in additional section 263A costs any negative
or positive adjustment required to be made as a result of differences
in financial statement and tax amounts of the taxpayer's de minimis
direct labor costs.
A taxpayer using a historic absorption ratio (HAR) that uses the de
minimis direct labor costs rule during its test period or updated test
period could treat a particular direct labor cost as an additional
section 263A cost in one year of the test period or updated test
period, and as a section 471 cost in a different year of the test
period or updated test period. The de minimis direct labor costs rule
provides a special rule that requires this taxpayer to use the SRM,
SPM, or MSPM and HAR during the qualifying period or extended
qualifying period in a manner that is most consistent with the
treatment of the direct labor costs during the test period or updated
test period. Under this rule, the taxpayer determines whether direct
labor costs are included in any of its section 471 costs remaining on
hand at year end during its qualifying period or extended qualifying
period consistent with how those direct labor costs were classified in
at least two of the three years of the taxpayer's applicable test
period or updated test period.
b. Direct Material Costs
The preamble to the proposed regulations stated that the proposed
regulations generally prohibited treating cash or trade discounts as
negative adjustments in additional section 263A costs under any of the
simplified methods. The proposed regulations expressly prohibited
treating cash or trade discounts as negative adjustments in additional
section 263A costs under the MSPM and the SRM, inadvertently omitting
taxpayers using the SPM from the prohibition. The operative rule in the
proposed regulations also specifically requested comments on reasonable
methods of allocating cash or trade discounts that taxpayers do not
capitalize for financial statement purposes between ending inventory
and cost of goods sold. In addition, the Treasury Department and the
IRS are aware that some taxpayers do not capitalize for financial
statement purposes certain direct material costs (for example,
transportation and other necessary charges incurred to acquire
possession of goods).
One commenter stated that the proposed regulations' treatment of
cash and trade discounts would impose an administrative burden on
taxpayers that do not treat any or all of their cash and trade
discounts as negative purchase or production costs for financial
statement purposes. The commenter suggested that, if the final
regulations preclude a taxpayer from treating cash and trade discounts
as negative additional section 263A costs, then taxpayers should be
allowed to allocate cash and trade discounts between ending inventory
and costs of goods sold using some type of averaging convention.
In general, cash and trade discounts related to section 471 costs,
and transportation and other necessary charges incurred to acquire
possession of goods, are treated as adjustments to the underlying
section 471 costs, and cannot be included as a negative adjustment in
additional section 263A costs. However, to reduce compliance costs,
burden, and administrative complexity, these final regulations provide
a de minimis direct material costs rule to allow taxpayers using the
SRM, SPM, or MSPM to include in additional section 263A costs, and
exclude from section 471 costs, certain direct material costs that are
uncapitalized financial statement costs. This de minimis direct
material costs rule can be used for certain direct material costs that
are not capitalized to property produced or property acquired for
resale in a taxpayer's financial statement (uncapitalized direct
material costs) such as cash discounts, trade discounts, and freight-in
costs. However, a taxpayer cannot use this de minimis direct material
costs rule to include in additional section 263A costs the types of
costs that are included in the taxpayer's standard cost method used for
section 471 costs (including cash and trade discounts).
Under this de minimis direct material costs rule, a taxpayer
includes in additional section 263A costs, and excludes from section
471 costs, the total amount of all direct material costs incurred in
the taxable year that are uncapitalized direct material costs, if the
amount of those costs in total comprise less than five percent of total
direct material costs incurred in the taxable year (whether or not
capitalized for financial statement purposes). The de minimis direct
material costs rule requires that any amounts that constitute a
reduction to costs, such as cash and trade discounts, be treated as
positive amounts for purposes of determining whether the taxpayer's
uncapitalized direct material costs meet the five percent test. The de
minimis
[[Page 58482]]
direct material costs rule operates similarly to the de minimis direct
labor costs rule for an alternative method taxpayer, and for a taxpayer
using a HAR. Because any direct material costs included in additional
section 263A costs after applying the de minimis direct material costs
rule are excluded from section 471 costs, such direct material costs
are not treated as section 471 costs for any purpose, including as
section 471 costs that are direct material costs in the modified
simplified production method formula.
10. Variances and Under- or Over-Applied Burdens
Both commenters stated that some taxpayers do not capitalize
certain variances related to direct costs to inventory for financial
statement purposes, and that the proposed regulations' requirement to
include all direct costs in section 471 costs would force these
taxpayers to create or purchase and maintain a second inventory costing
system for tax purposes only. The IRS's established administrative
practice requires taxpayers to treat positive and negative cost
variances and under or over-applied burden amounts related to direct
and indirect section 471 costs as adjustments to the underlying section
471 costs. However, to reduce compliance costs, burden, and
administrative complexity, these final regulations provide a safe
harbor rule for taxpayers using the SRM, SPM, or MSPM to include in
additional section 263A costs, and exclude from section 471 costs,
certain variances and under or over-applied burdens that are not
capitalized to property produced or property acquired for resale in the
taxpayer's financial statement (uncapitalized variances or
uncapitalized under or over-applied burdens).
Under this safe harbor rule, a taxpayer includes in additional
section 263A costs, and excludes from section 471 costs, the sum of the
amounts of all of those uncapitalized variances and uncapitalized under
or over-applied burdens for that taxable year, if such sum is less than
five percent of the taxpayer's total section 471 costs for all items
for which the taxpayer uses a standard cost or burden rate method to
allocate costs. For purposes of this rule, total section 471 costs for
all items for which the taxpayer uses a standard cost or burden rate
method to allocate costs are computed before application of the safe
harbor method, and must reflect the actual amounts incurred by the
taxpayer on these items, which therefore include variances and under or
over-applied burdens. If the sum of the amounts of all of those
uncapitalized variances and uncapitalized under or over-applied burdens
in a taxable year are not less than five percent for the taxable year,
the taxpayer must reallocate such uncapitalized amounts to or among
units of property as required by Sec. 1.263A-1(f)(3)(i)(C) or
(f)(3)(ii)(B), respectively.
Under this safe harbor rule, all variances and under or over-
applied burdens are treated as positive amounts for purposes of
determining whether the taxpayer's uncapitalized variances and
uncapitalized under or over-applied burdens meet this five percent
test. Additionally, this safe harbor rule applies to any variances on
cash or trade discounts that are included in the taxpayer's standard
cost, if those discounts are capitalized as part of the taxpayer's
standard cost method used for section 471 costs. An eligible taxpayer
must consistently apply the safe harbor method to all items for which
the taxpayer uses a standard cost or burden rate method to allocate
costs. However, the safe harbor rule only applies to a taxpayer's
uncapitalized variances and uncapitalized under or over-applied
burdens. In addition, a taxpayer using this safe harbor rule is not
permitted to treat uncapitalized variances and uncapitalized under or
over-applied burdens that are not significant as not allocable to
property produced or property acquired for resale under Sec. 1.263A-
1(f)(3)(i)(C) and (f)(3)(ii)(B), respectively.
Finally, for taxpayers using either the SRM or MSPM, allocation
rules are provided to help taxpayers allocate these uncapitalized costs
between storage and handling costs and current year purchasing costs,
in the case of the SRM, and pre-production and production costs, in the
case of the MSPM.
11. Smaller Taxpayers Using the SPM
The proposed regulations allowed taxpayers with average annual
gross receipts of $10,000,000 or less for the three previous taxable
years to include negative adjustments in additional section 263A costs
under the SPM.
One commenter stated that average annual gross receipts of
$10,000,000 or less does not accurately represent a ``small taxpayer.''
The commenter suggested using the average aggregate value of ending
inventory, rather than gross receipts, to identify this group of
taxpayers. Both commenters also stated that small taxpayers would have
difficulty complying with the MSPM.
The Treasury Department and the IRS do not believe that an average
aggregated ending inventory value accurately identifies smaller
taxpayers because inventory value can fluctuate greatly within the
taxable year, or from year to year. Accordingly, this suggestion is not
adopted. However, to reduce compliance costs and burden for smaller
taxpayers using the SPM and minimize the difficulty that smaller
taxpayers may face complying with the MSPM, these final regulations
allow taxpayers with average annual gross receipts of $50,000,000 or
less for the three previous taxable years to include negative
adjustments in additional section 263A costs under the SPM.
12. Comments Regarding the HAR and the MSPM
The proposed regulations provided that a taxpayer using the MSPM
could make the HAR election. Under the proposed regulations, a non-
LIFO-method taxpayer using the MSPM with the HAR election calculates
both a pre-production HAR and a production HAR, to be used for each
taxable year within a qualifying period (in place of the actual pre-
production absorption ratio and actual production absorption ratio). In
the first taxable year following the close of a qualifying period--the
recomputation year--if the taxpayer's actual pre-production absorption
ratio or actual production absorption ratio is not within one-half of
one percentage point (plus or minus) of the corresponding HAR, the
taxpayer must use actual absorption ratios during an updated test
period, and the qualifying period is not extended. A LIFO-method
taxpayer using the MSPM with the HAR election, however, calculates a
combined HAR to be used for each taxable year within a qualifying
period (in place of the actual combined absorption ratio). In the
recomputation year, if the LIFO-method taxpayer's actual combined
absorption ratio is not within one-half of one percentage point (plus
or minus) of the combined HAR, the taxpayer must use an actual combined
absorption ratio during an updated test period, and the qualifying
period is not extended.
One commenter suggested that the rules for determining whether a
qualifying period is extended for LIFO taxpayers should also apply to
non-LIFO-method taxpayers, and therefore, in the recomputation year,
all taxpayers should use a combined HAR to compare to an actual
combined absorption ratio. This suggestion is not adopted because
calculating combined absorption ratios does not match the ratios
required to be calculated by a non-LIFO-method taxpayer using the MSPM.
A non-LIFO-method taxpayer using the MSPM is
[[Page 58483]]
required to calculate separate absorption ratios, even when using the
HAR.
The proposed regulations also specifically requested comments on
transition rules for taxpayers currently using the SPM with the HAR
election that change to the MSPM, including comments on how the
regulations should apply to taxpayers within a qualifying period as
described in Sec. 1.263A-2(b)(4)(ii)(C). One commenter suggested
allowing taxpayers currently using the HAR that are changing to the
MSPM with the HAR election to open a new test period. Additionally, one
commenter suggested that taxpayers be permitted to make the change
using a section 481(a) adjustment instead of a cut-off method.
Except as otherwise expressly provided by the Code or the
regulations thereunder, section 446(e) and Sec. 1.446-1(e)(2) require
a taxpayer to secure the consent of the Commissioner before changing a
method of accounting for federal income tax purposes. Section 1.446-
1(e)(3)(ii) authorizes the Commissioner to prescribe administrative
procedures setting forth the terms and conditions necessary for a
taxpayer to obtain consent to a change in method of accounting. Revenue
Procedure 2015-13, 2015-5 IRB 419, as clarified and modified by Rev.
Proc. 2015-33, 2015-24 IRB 1067, as modified by Rev. Proc. 2016-1,
2016-1 IRB 1, and as modified by Rev. Proc. 2017-59, 2017-48 IRB 543,
provides the general procedures by which a taxpayer may obtain
automatic consent of the Commissioner to a change in method of
accounting described in Rev. Proc. 2018-31, 2018-22 IRB 637. The
automatic consent procedures reduce filing requirements, waive user
fees, and extend filing deadlines normally associated with a request
for change in method of accounting.
Simultaneously with the publication of these final regulations, the
Treasury Department and the IRS are issuing Revenue Procedure 2018-56
(2018-50 IRB) to modify Rev. Proc. 2018-31 and provide the procedures
by which a taxpayer may obtain automatic consent to make certain method
changes to conform to these final regulations, such as a change to the
MSPM by a taxpayer using the HAR.
13. Procedural Requirements for Changing Section 471 Costs or Changing
to the MSPM
The proposed regulations did not provide procedural rules for
taxpayers changing to comply with the final regulations. One commenter
suggested that the automatic change procedures apply or that procedures
be implemented allowing the change to be made on an expedited basis.
Simultaneously with the publication of these final regulations, the
Treasury Department and the IRS are issuing Revenue Procedure 2018-56
to modify Rev. Proc. 2018-31 and provide the procedures by which a
taxpayer may obtain automatic consent to make certain method changes to
conform to these final regulations, such as a change to comply with the
new definition of section 471 costs or a change to the MSPM.
Effective Date
These final regulations are generally effective as of November 20,
2018 and apply for taxable years beginning on or after November 20,
2018. For any taxable year that both begins before November 20, 2018
and ends after November 20, 2018, the IRS will not challenge return
positions consistent with all of these final regulations.
Special Analyses
Regulatory Planning and Review--Economic Analysis
Executive Orders 13563 and 12866 direct agencies to assess costs
and benefits of available regulatory alternatives and, if regulation is
necessary, to select regulatory approaches that maximize net benefits
(including potential economic, environmental, public health and safety
effects, distributive impacts, and equity). Executive Order 13563
emphasizes the importance of quantifying both costs and benefits,
reducing costs, of harmonizing rules, and of promoting flexibility.
These final regulations have been designated by the Office of
Information and Regulatory Affairs (OIRA) as Significant under
Executive Order 12866 and section 1(b) of the Memorandum of Agreement
(April 11, 2018) between the Treasury Department and the Office of
Management and Budget (OMB) regarding review of tax regulations and
thereby subject to review under Executive Order 12866. Accordingly,
these final regulations have been reviewed by OIRA.
A. Overview
These final regulations provide taxpayers with computational and
definitional guidance regarding the application of section 263A under
the simplified methods. Specifically, they provide guidance for
taxpayers to determine the amount of additional section 263A costs to
capitalize and make several changes regarding the application of
section 263A under the simplified methods to reduce compliance costs,
burden, and administrative complexity. This economic analysis describes
the economic benefits and costs of these final regulations.
B. Economic Analysis of the Final Regulations
1. Background
For a discussion of the background of these final regulations, see
the Background sections of this preamble and the proposed regulations.
2. Anticipated Benefits and Costs of the Final Regulations
a. Baseline
The Treasury Department and the IRS have assessed the benefits and
costs of these final regulations against a status quo baseline that
reflects projected tax-related and other behavior in the absence of
these final regulations and includes the effect of Notice 2007-29.
Notice 2007-29 allows taxpayers to include negative adjustments in
computing additional costs under section 263A and allows aggregate
negative additional section 263 costs.
b. Anticipated Benefits
The Treasury Department and the IRS expect that the certainty and
clarity provided by these final regulations as well as the substantive
contribution of the regulations will enhance economic efficiency
relative to the baseline.
In developing these final regulations, the Treasury Department and
the IRS have generally aimed to apply the principle that an
economically efficient tax system would treat income derived from
similar economic decisions similarly, to the extent consistent with the
Code and considerations of administrability of the tax system.
An economically efficient tax system would generally allow
businesses to deduct from income taxes an amount meant to capture the
economic cost of their capital investments. Under this principle, rules
for capitalization and deductions are most efficient when they most
closely mimic true economic depreciation. This conclusion is
complicated by a large number of real world factors, including that
economic depreciation is endogenous and difficult to measure and that
the tax system itself will affect true depreciation. Furthermore, the
principles from which the true-economic-depreciation prescription is
derived are themselves based on a ``pure'' tax system rather than the
complex real world tax code. The Treasury Department and the IRS do not
anticipate substantial changes to
[[Page 58484]]
the aggregate cost of goods sold, the aggregate tax bases of other
produced assets, or the depreciation deductions that will be generated
under the new simplified method, the MSPM, relative to the baseline.
Therefore these final regulations should not materially affect
aggregate tax revenues or aggregate inventory investment relative to
the baseline. There may be some modest increase in investment in
inventory. For example, investment in raw materials inventory may
increase under these final regulations because the relative tax cost of
buying and carrying raw materials under the MSPM is generally less than
under the SPM. Treatment of inventory under the simplified methods
generally remains the same. Because the tax system requires a periodic
determination of inventory, there was and still is, an incentive to
minimize inventory as of that date, usually the end of the taxable
year. The increased investment in raw materials inventory under the
MSPM is due to the fact that inventory as of the determination date may
be divided into pre-production and production inventory and a specific
rate is applied to estimate overhead for each category. While under the
SPM the inventory as of the determination date is not divided and one
rate is used to estimate overhead for all inventory. There may also be
a modest shifting of investment between different types of inventory
because the MSPM should improve the measurement of certain types of
final inventory and improved precision would generally lead to small
adjustments in inventory amounts. Though no specific types of inventory
are treated favorably, the modest shifting of investment is expected
because the reduced carrying cost associated with maintaining raw
materials inventory may encourage or allow some taxpayers to carry a
larger quantity of raw materials for business purposes.
c. Anticipated Impacts on Administrative and Compliance Costs
The Treasury Department and the IRS expect that the certainty,
clarity, and simplifying changes regarding the application of section
263A provided by these final regulations, relative to the baseline,
will reduce annual compliance costs, burden, and administrative
complexity. Absent these final regulations, different parties would
continue to take different positions regarding the inclusion of
negative adjustments in computing additional costs under section 263A
and the permissibility of aggregate negative additional section 263A
costs. More uniform positions by taxpayers will in general reduce the
costs of tax administration.
For taxpayers, the major cost savings of these final regulations
derive from the reduction in the computational and record-keeping
burdens involved with the use of the simplified methods for calculating
end-of-year inventory. These burdens are reduced because taxpayers will
now generally be able to use their own current financial accounting
methods to determine their section 471 costs, albeit using cost amounts
determined under tax law. Taxpayers with audited financial statements,
or those who file regulatory financial statements, will also be able to
use cost amounts determined according to financial accounting rules. In
addition, taxpayers using a simplified method will be able to make
positive and negative adjustments to their additional section 263A
costs in cases where their section 471 costs, determined using
financial accounting methods, either do not capitalize all actual costs
or over-capitalize those costs. Finally, taxpayers using the SRM or the
MSPM, and smaller taxpayers (those with average gross receipts of $50
million or less) using the SPM will be able to make negative
adjustments to their additional section 263A costs in cases where the
capitalization of certain costs is either optional or not permitted
under the tax law. It is anticipated that larger taxpayers using the
SPM who desire such treatment will switch from using the SPM to the
MSPM in order to continue to make these negative adjustments.
In addition, absent these final regulations, taxpayers and the IRS
would: (1) Continue to be required to use definitions based on a
taxpayer's accounting practices used in 1986; (2) continue to be
required to use tax accounting rules, rather than their own financial
accounting rules, to determine the allocation of certain capitalized
amounts; (3) not be able to use the MSPM to more precisely determine
the lump-sum of costs to capitalize; (4) not be able to use the new
safe-harbors for direct labor and direct material costs not capitalized
on a taxpayer's financial statements; and (5) not be able to use the de
minimis rules for variances and under- or over-applied burden not
capitalized on a taxpayer's financial statements. The changes in each
of these directions under the final regulations will generally reduce
taxpayer compliance costs. For example, under these final regulations,
one definition of section 471 costs applies to all taxpayers,
regardless of when the taxpayer came into existence. Previously,
taxpayers in existence when section 263A was enacted were required to
use definitions based on their actual tax cost accounting practices as
of enactment. However, taxpayers that were not in existence when
section 263A was enacted were required to use definitions based on what
their tax cost accounting practices would have been as of enactment
under the law at that time. Under these final regulations, all
taxpayers use their present financial statement cost accounting
practices. Moreover, taxpayers using the simplified resale method or
simplified production method will benefit from no longer being required
to adjust their section 471 costs incurred during the taxable year to
reflect tax adjustments in their respective simplified method formula.
Rather, these simplified method taxpayers may use an alternative method
that permits them to use their financial statement amounts for their
section 471 costs incurred during the taxable year and make tax
adjustments to these costs by using negative adjustments to their
section 263A costs.
The most recently available Statistics of Income (SOI) indicates
that approximately 30,000 taxpayers were subject to section 263A in
2015 and would be impacted by these final regulations. While the number
of affected taxpayers will increase with growth in the economy, the
Treasury Department and the IRS do not expect that these final
regulations will change the portion of affected taxpayers that use a
simplified method because those taxpayers not using a simplified method
will likely continue to allocate capitalizable costs to specific items
of property under their present method, and taxpayers using a
simplified method are not likely to begin capitalizing costs to
specific items of property due to these final regulations. The IRS's
Office of Research, Applied Analytics, and Statistics (RAAS) estimate
that these 30,000 taxpayers spent approximately 315,000 hours and $26
million ($2015) annually to comply with the simplified methods, as
implemented under Notice 2007-29. The dollar burden is derived from
RAAS's Business Taxpayer Burden model that relates time and out-of-
pocket costs of business tax preparation, derived from survey data, to
assets and receipts of affected taxpayers along with other relevant
variables, and converted by the Treasury Department to $2015. See Tax
Compliance Burden (John Guyton et al, July 2018) at https://www.irs.gov/pub/irs-soi/d13315.pdf. The Treasury Department and IRS
then used this framework to estimate the
[[Page 58485]]
taxpayer burden associated with section 263A compliance under the final
regulations. These estimates reflect the Treasury Department's and
IRS's estimate that because these final regulations implement an
approach substantially consistent with current practice, but also offer
taxpayers additional compliance simplifications, these final
regulations will result in a reduction in the aggregate annual taxpayer
compliance burden of approximately ten percent. The estimated reduction
in annual compliance burden for impacted taxpayers is summarized below.
Estimated Reduction in Annual Compliance Burden (2015 levels)
----------------------------------------------------------------------------------------------------------------
Final Burden
Baseline regulations reduction
----------------------------------------------------------------------------------------------------------------
Taxpayers....................................................... 30,000 30,000 -
Hours........................................................... 315,000 283,500 31,500
Cost ($2015).................................................... $26,000,000 $23,400,000 $2,600,000
----------------------------------------------------------------------------------------------------------------
C. Paperwork Reduction Act
The collection of information in these final regulations is in
Sec. 1.263A-2(c)(4)(i). The collection of information in Sec. 1.263A-
2(c)(4)(i) only applies to taxpayers using the MPSM with HAR. The
burden for the collection of information contained in these final
regulations is reflected in the burden for Sec. Sec. 1.263A-
2(b)(4)(iii)(A) and (B) and 1.263A-3(d)(4)(iii)(A) and (B) and is not
expected to change the previously determined estimated annual burden
per respondent, the estimated annual burden per recordkeeper, or the
estimated number of respondents because (i) taxpayers could previously
use a simplified method with HAR, (ii) these final regulations do not
make a simplified method with HAR more or less desirable, and (iii)
only those taxpayers previously using a simplified method with HAR are
likely to do so under these final regulations. For purposes of the
Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)), the reporting
burden associated with Sec. 1.263A-2(c)(4)(i) will be reflected in the
IRS Form 14029, Paperwork Reduction Act Submission, associated with
Form 1120 (OMB control number 1545-0123) at www.reginfo.gov/public/do/PRAViewICR?ref_nbr=201706-1545-005.
D. Executive Order 13771
These final regulations are expected to be an Executive Order 13771
deregulatory action. Details on the estimated effects of this rule can
be found in the rule's economic analysis.
E. Regulatory Flexibility Analysis
It is hereby certified that these final regulations will not have a
significant economic impact on a substantial number of small entities.
This certification is based on the fact that: (1) Many small business
taxpayers are no longer required to capitalize costs under section 263A
if their average annual gross receipts are less than $25,000,000; (2) a
taxpayer with average annual gross receipts of less than $50,000,000
may continue to use the simplified production method and the simplified
production method with a historical absorption rate (HAR) with negative
amounts in additional section 263A costs; and (3) a relatively small
number of taxpayers use a simplified method with HAR compared to a
simplified method without HAR and, therefore, it is expected that few
small business taxpayers will use the modified simplified production
method with HAR. Thus, a Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
F. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a state,
local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. In 2018, that threshold is approximately $150 million. This
rule does not include any Federal mandate that may result in
expenditures by state, local, or tribal governments, or by the private
sector in excess of that threshold.
G. Executive Order 13132: Federalism
Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. This rule does not have federalism
implications and does not impose substantial direct compliance costs on
state and local governments or preempt state law within the meaning of
the Executive Order.
Drafting Information
The principal author of these final regulations is Natasha M.
Mulleneaux of the Office of Associate Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and the Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART I--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by revising
the sectional authority entries for Sec. Sec. 1.263A-1, 1.263A-2,
1.263A-3 and 1.263A-7, and adding a sectional authority for Sec.
1.471-3 in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805.
* * * * *
Section 1.263A-1 also issued under 26 U.S.C. 263A(j).
Section 1.263A-2 also issued under 26 U.S.C. 263A(j).
Section 1.263A-3 also issued under 26 U.S.C. 263A(j).
* * * * *
Section 1.263A-7 also issued under 26 U.S.C. 263A(j).
* * * * *
Section 1.471-3 issued under 26 U.S.C. 471(a).
* * * * *
0
Par. 2. Section 1.263A-0 is amended by:
0
1. Revising the entry for Sec. 1.263A-1(d)(2)(ii).
0
2. Adding entries for Sec. 1.263A-1(d)(2)(ii)(A) and (B).
[[Page 58486]]
0
3. Revising the entry for Sec. 1.263A-1(d)(2)(iii).
0
4. Adding entries for Sec. 1.263A-1(d)(2)(iii)(A) through (E),
(d)(2)(iv), (d)(2)(iv)(A) through (E), (d)(2)(v), (d)(2)(v)(A) through
(E), and (d)(2)(vi) and (vii).
0
5. Adding entries for Sec. 1.263A-1(d)(3)(i), (d)(3)(ii), and
(d)(3)(ii)(A) through (E).
0
6. Adding entries for Sec. 1.263A-1(d)(5) and (6).
0
7. Adding entries for Sec. 1.263A-2(b)(4)(v)(A) and (B).
0
8. Revising the entry for Sec. 1.263A-2(c).
0
9. Adding entries for Sec. 1.263A-2(c)(1), (c)(2), (c)(2)(i) and (ii),
(c)(3), (c)(3)(i), (c)(3)(i)(A) and (B), (c)(3)(ii), (c)(3)(ii)(A) and
(B), (c)(3)(ii)(B)(1) and (2), (c)(3)(ii)(C) and (D), (c)(3)(ii)(D)(1)
through (4), (c)(3)(ii)(E) and (F), (c)(3)(iii), (c)(3)(iii)(A) through
(C), (c)(3)(iv), (c)(3)(iv)(A) and (B), (c)(3)(iv)(B)(1) and (2),
(c)(3)(iv)(C), (c)(3)(v) and (vi), (c)(4), (c)(4)(i) and (ii),
(c)(4)(ii)(A) and (B), (c)(4)(iii), (c)(4)(iii)(A) and (B),
(c)(4)(iii)(B)(1) and (2), and (c)(4)(iv) and (v).
0
10. Revising the entry for Sec. 1.263A-2(d).
0
11. Revising the entry for Sec. 1.263A-2(e).
0
12. Removing the entries for Sec. 1.263A-2(e)(1) through (5).
0
13. Revising the entry for Sec. 1.263A-2(f).
0
14. Adding entries for Sec. 1.263A-2(f)(1) through (5).
0
15. Adding an entry for Sec. 1.263A-2(g).
0
16. Adding entries for Sec. 1.263A-3(d)(4)(v)(A) and (B).
The revisions and additions read as follows:
Sec. 1.263A-0 Outline of regulations under section 263A.
* * * * *
Sec. 1.263A-1 Uniform Capitalization of Costs.
* * * * *
(d) * * *
(2) * * *
(ii) Inclusion of direct costs.
(A) In general.
(B) Allocation of direct costs.
(iii) Alternative method to determine amounts of section 471 costs
by using taxpayer's financial statement.
(A) In general.
(B) Book-to-tax adjustments.
(C) Exclusion of certain financial statement items.
(D) Changes in method of accounting.
(E) Examples.
(iv) De minimis rule exceptions for certain direct costs.
(A) In general.
(B) De minimis rule for certain direct labor costs.
(C) De minimis rule for certain direct material costs.
(D) Taxpayers using a historic absorption ratio.
(E) Examples.
(v) Safe harbor method for certain variances and under or over-
applied burdens.
(A) In general.
(B) Consistency requirement.
(C) Allocation of variances and under or over-applied burdens
between production and preproduction costs under the modified
simplified production method.
(D) Allocation of variances and under or over-applied burdens
between storage and handling costs absorption ratio and purchasing
costs absorption ratio under the simplified resale method.
(E) Method of accounting.
(vi) Removal of section 471 costs.
(vii) Method changes.
(3) * * *
(i) In general.
(ii) Negative adjustments.
(A) In general.
(B) Exception for certain taxpayers removing costs from section 471
costs.
(C) No negative adjustments for cash or trade discounts.
(D) No negative adjustments for certain expenses.
(E) Consistency requirement for negative adjustments.
(4) Section 263A costs.
(5) Classification of costs.
(6) Financial statement.
* * * * *
Sec. 1.263A-2 Rules Relating to Property Produced by the Taxpayer.
* * * * *
(b) * * *
(4) * * *
(v) * * *
(A) Transition to elect historic absorption ratio.
(B) Transition to revoke historic absorption ratio.
* * * * *
(c) Modified simplified production method.
(1) Introduction.
(2) Eligible property.
(i) In general.
(ii) Election to exclude self-constructed assets.
(3) Modified simplified production method without historic
absorption ratio election.
(i) General allocation formula.
(A) In general.
(B) Effect of allocation.
(ii) Definitions.
(A) Direct material costs.
(B) Pre-production absorption ratio.
(1) Pre-production additional section 263A costs.
(2) Pre-production section 471 costs.
(C) Pre-production section 471 costs remaining on hand at year end.
(D) Production absorption ratio.
(1) Production additional section 263A costs.
(2) Residual pre-production additional section 263A costs.
(3) Production section 471 costs.
(4) Direct materials adjustment.
(E) Production section 471 costs remaining on hand at year end.
(F) Costs allocated to property sold.
(iii) Allocable mixed service costs.
(A) In general.
(B) Taxpayer using the simplified service cost method.
(C) De minimis rule.
(iv) LIFO taxpayers electing the modified simplified production
method.
(A) In general.
(B) LIFO increment.
(1) In general.
(2) Combined absorption ratio defined.
(C) LIFO decrement.
(v) De minimis rule for producers with total indirect costs of
$200,000 or less.
(vi) Examples.
(4) Modified simplified production method with historic absorption
ratio election.
(i) In general.
(ii) Operating rules and definitions.
(A) Pre-production historic absorption ratio.
(B) Production historic absorption ratio.
(iii) LIFO taxpayers making the historic absorption ratio election.
(A) In general.
(B) Combined historic absorption ratio.
(1) Total allocable additional section 263A costs incurred during
the test period.
(2) Total section 471 costs remaining on hand at each year end of
the test period.
(iv) Extension of qualifying period.
(v) Examples.
(d) Additional simplified methods for producers.
(e) Cross reference.
(f) Change in method of accounting.
(1) In general.
(2) Scope limitations.
(3) Audit protection.
(4) Section 481(a) adjustment.
(5) Time for requesting change.
(g) Effective/applicability date.
Sec. 1.263A-3 Rules Relating to Property Acquired for Resale.
* * * * *
(d) * * *
[[Page 58487]]
(4) * * *
(v) * * *
(A) Transition to elect historic absorption ratio.
(B) Transition to revoke historic absorption ratio.
* * * * *
0
Par. 3. Section 1.263A-1 is amended by:
0
1. Revising the last sentence of paragraph (c)(1).
0
2. Revising paragraphs (d)(2) and (3).
0
3. Adding paragraphs (d)(5) and (6).
0
4. Revising the third sentence of paragraph (f)(1).
0
5. In paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B), removing the language
``financial reports'' and adding ``financial statement'' in its place.
0
6. Revising paragraph (h)(9).
0
7. Adding paragraph (l)(5).
The revisions and additions read as follows:
Sec. 1.263A-1 Uniform capitalization of costs.
* * * * *
(c) * * *
(1) * * * See however, the simplified production method, the
modified simplified production method, and the simplified resale method
in Sec. Sec. 1.263A-2(b) and (c) and 1.263A-3(d).
* * * * *
(d) * * *
(2) Section 471 costs--(i) In general. Except as otherwise provided
in paragraphs (d)(2)(ii), (iv), (v), and (vi) of this section, for
purposes of section 263A, a taxpayer's section 471 costs are the types
of costs, other than interest, that a taxpayer capitalizes to property
produced or property acquired for resale in its financial statement.
Thus, although section 471 applies only to inventories, section 471
costs include any non-inventory costs, other than interest, that a
taxpayer capitalizes to, or includes in acquisition or production costs
of, property produced or property acquired for resale in its financial
statement. Except as otherwise provided in paragraph (d)(2)(iii) of
this section, a taxpayer determines the amounts of section 471 costs by
using the amounts of such costs that are incurred in the taxable year
for federal income tax purposes.
(ii) Inclusion of direct costs--(A) In general. Notwithstanding the
last sentence of paragraph (g)(2) of this section, a taxpayer's section
471 costs must include all direct costs of property produced and
property acquired for resale, whether or not a taxpayer capitalizes
these costs to property produced or property acquired for resale in its
financial statement. See paragraph (e)(2) of this section for a
description of direct costs of property produced and property acquired
for resale.
(B) Allocation of direct costs. Except for any direct costs that
are treated as additional section 263A costs under paragraphs
(d)(2)(iv) and (v) of this section, a taxpayer's direct costs of
property produced and property acquired for resale must be allocated
using a method provided in paragraph (f) of this section.
(iii) Alternative method to determine amounts of section 471 costs
by using taxpayer's financial statement--(A) In general. In lieu of
determining the amounts of section 471 costs under paragraph (d)(2)(i)
of this section, a taxpayer described in paragraph (d)(3)(ii)(B) of
this section may determine the amounts of section 471 costs by using
the amounts of such costs that are incurred in the taxable year in its
financial statement using the taxpayer's financial statement methods of
accounting if the taxpayer's financial statement is described in
paragraph (d)(6)(i), (ii), or (iii) of this section. If the taxpayer's
financial statement is described only in paragraph (d)(6)(iv) of this
section, the taxpayer may not use the alternative method described in
this paragraph (d)(2)(iii) and must use the method described in
paragraph (d)(2)(i) of this section to determine its amounts of section
471 costs. A taxpayer using the alternative method described in this
paragraph (d)(2)(iii) must remove all section 471 costs described in
paragraph (d)(2)(vi) of this section, if any, by including negative
adjustments in additional section 263A costs. A taxpayer using the
alternative method described in this paragraph (d)(2)(iii) applies the
method to all of its section 471 costs, including costs described under
paragraphs (d)(2)(ii), (iv), (v), and (vi) of this section.
(B) Book-to-tax adjustments. A taxpayer using the alternative
method described in this paragraph (d)(2)(iii) must include as
additional section 263A costs all negative and positive adjustments
required to be made as a result of differences in the book and tax
amounts of the taxpayer's section 471 costs, including adjustments for
direct costs required to be added to section 471 costs under paragraph
(d)(2)(ii) of this section, and costs removed from section 471 costs
under paragraphs (d)(2)(vi) and (d)(3)(ii)(B) of this section. In
addition, the taxpayer must include as additional section 263A costs
all negative and positive adjustments required to be made as a result
of differences in the book and tax amounts of section 471 costs that
are treated as additional section 263A costs (for example, de minimis
direct costs described in paragraph (d)(2)(iv) of this section and
certain variances and under or over-applied burdens described in
paragraph (d)(2)(v) of this section). For purposes of determining the
negative and positive adjustments required to be made as a result of
differences in book and tax amounts for a taxpayer using the burden
rate or standard cost methods described in paragraph (f)(3) of this
section, the taxpayer compares the actual amount of the cost incurred
in the taxable year for federal income tax purposes to the actual
amount of the cost incurred in the taxable year in its financial
statement using the taxpayer's financial statement methods of
accounting, regardless of how the taxpayer treats its variances or
under or over-applied burdens.
(C) Exclusion of certain financial statement items. A taxpayer that
determines the amounts of section 471 costs under this paragraph
(d)(2)(iii) may not include any financial statement write-downs,
reserves, or other financial statement valuation adjustments when
determining the amounts of its section 471 costs.
(D) Changes in method of accounting. The use of this method to
determine the amounts of section 471 costs under this paragraph
(d)(2)(iii) is the adoption of, or a change in, a method of accounting
under section 446 of the Internal Revenue Code.
(E) Examples. The following examples illustrate this paragraph
(d)(2)(iii):
(1) Example 1--Alternative-method taxpayer using de minimis
direct labor costs rule. Taxpayer P uses the modified simplified
production method described in Sec. 1.263A-2(c) and determines its
amounts of section 471 costs by using the alternative method under
paragraph (d)(2)(iii) of this section. Additionally, P uses the de
minimis direct labor costs rule under paragraph (d)(2)(iv)(B) of
this section. P does not capitalize vacation pay or holiday pay to
property produced or property acquired for resale in its financial
statement but does capitalize all other direct labor costs to such
property in its financial statement. On its 2018 financial
statement, P incurs $3,500,000 of total direct labor costs,
including $110,000 of vacation pay costs and $10,000 of holiday pay
costs. For federal income tax purposes, P incurs $150,000 of
vacation pay costs and $18,000 of holiday pay costs in the taxable
year. P's uncapitalized direct labor costs are $120,000 ($110,000 of
vacation pay plus $10,000 of holiday pay). For purposes of the five
percent test in paragraph (d)(2)(iv)(B) of this section, P's
uncapitalized direct labor costs are 3.43% of total direct labor
costs ($120,000 divided by $3,500,000). Accordingly, under paragraph
(d)(2)(iv)(B) of this section, P includes $120,000 in its additional
section 263A costs and excludes that amount from its section 471
costs in the taxable year. Additionally, pursuant to paragraph
(d)(2)(iii)(B) of this section, P includes in
[[Page 58488]]
additional section 263A costs a positive book-to-tax adjustment of
$40,000 for vacation pay costs ($150,000 tax amount-$110,000 book
amount) and a positive book-to-tax adjustment of $8,000 for holiday
pay costs ($18,000 tax amount-$10,000 book amount).
(2) Example 2--Alternative-method taxpayer with under and over-
applied burdens that uses safe harbor rule for certain variances and
under or over-applied burdens. Taxpayer X uses the modified
simplified production method described in Sec. 1.263A-2(c) and
determines its amounts of section 471 costs by using the alternative
method under paragraph (d)(2)(iii) of this section. In 2018, X uses
a burden rate method for book purposes to allocate costs to Products
A and B, and does not capitalize any under or over-applied burdens
to property produced or property acquired for resale in its
financial statement. X does not allocate costs to any other products
using a burden rate method, and X does not allocate costs to any
products using a standard cost method. On its 2018 financial
statement, using X's burden rate, the total amount of predetermined
indirect costs for Product A is $545,000 and the total amount of
actual indirect costs incurred for Product A is $550,000;
accordingly, X has an under-applied burden of $5,000 for Product A.
For federal income tax purposes, the actual indirect costs incurred
in 2018 for Product A is $560,000. Additionally, on its 2018
financial statement, using X's burden rate, the total amount of
predetermined indirect costs for Product B is $250,000 and the total
amount of actual indirect costs incurred for Product B is $225,000;
accordingly, X has an over-applied burden of $25,000 for Product B.
For federal income tax purposes, the actual indirect costs incurred
in 2018 for Product B is $240,000. X uses the safe harbor rule for
certain variances and under or over-applied burdens. Prior to the
application of this safe harbor rule, X's total section 471 costs
for 2018 for Products A and B (the only items to which X allocates
costs using a standard cost method or burden rate method) are
$2,000,000, which includes $550,000 actual indirect costs for
Product A, $225,000 actual indirect costs for Product B, and
$1,225,000 of other section 471 costs for Products A and B that are
not allocated under X's burden rate method. For purposes of
determining the amount of uncapitalized variances and uncapitalized
under or over-applied burdens for the five percent test in paragraph
(d)(2)(v)(A) of this section, X's under and over-applied burdens for
Products A and B are treated as positive amounts. Consequently, the
sum of X's uncapitalized variances and uncapitalized under or over-
applied burdens is $30,000 ($5,000 under-applied burden for Product
A plus $25,000 over-applied burden for Product B). Accordingly,
under paragraph (d)(2)(v)(A) of this section, the sum of X's
uncapitalized variances and uncapitalized under or over-applied
burdens is 1.5% of X's total section 471 costs for all items to
which it allocates costs using a standard cost method or burden rate
method ($30,000 divided by $2,000,000), and X includes a positive
$5,000 under-applied burden for Product A and a negative $25,000
over-applied burden for Product B in its additional section 263A
costs, and excludes those amounts from its section 471 costs.
Additionally, pursuant to paragraph (d)(2)(iii)(B) of this section,
X includes in its additional section 263A costs a positive book-to-
tax adjustment of $10,000 for Product A ($560,000 actual cost tax
amount-$550,000 actual cost book amount) and a positive book-to-tax
adjustment of $15,000 for Product B ($240,000 actual tax amount
cost-$225,000 actual book amount cost) in the taxable year.
(iv) De minimis rule exceptions for certain direct costs--(A) In
general. Notwithstanding paragraph (d)(2)(ii) of this section, a
taxpayer that uses the simplified resale method, the simplified
production method, or the modified simplified production method, and
that does not capitalize certain direct costs to property produced or
property acquired for resale in its financial statement (uncapitalized
direct labor costs or uncapitalized direct material costs), may use
either or both the de minimis direct labor costs rule or the de minimis
direct material costs rule to include in additional section 263A costs,
and exclude from section 471 costs, certain uncapitalized direct labor
costs or uncapitalized direct material costs that are incurred in the
taxable year as provided in paragraphs (d)(2)(iv)(B) and (C) of this
section, respectively. The use of the de minimis rules described in
paragraphs (d)(2)(iv)(B) and (C) of this section is the adoption of, or
a change in, a method of accounting under section 446 of the Internal
Revenue Code.
(B) De minimis rule for certain direct labor costs. A taxpayer
described in paragraph (d)(2)(iv)(A) of this section that uses the de
minimis rule described in this paragraph (d)(2)(iv)(B) includes in
additional section 263A costs, and excludes from section 471 costs, the
sum of the amounts of all of those uncapitalized direct labor costs
that are incurred in the taxable year, if that sum is less than five
percent of total direct labor costs incurred in the taxable year
(whether or not capitalized in the taxpayer's financial statement), or
another amount specified in other published guidance (see Sec.
601.601(d)(2) of this chapter). For purposes of determining the amount
of uncapitalized direct labor costs for this five percent test, any
amounts that constitute a reduction to costs are treated as a positive
amount. The amounts of uncapitalized direct labor costs used for the
five percent test, and the amounts of uncapitalized direct labor costs
included in additional section 263A costs under this paragraph
(d)(2)(iv)(B), must not include amounts relating to basic compensation
or overtime, or the types of costs included in the taxpayer's standard
cost or burden rate methods used for section 471 costs (but see
paragraphs (d)(2)(v) and (f)(3)(i)(C) of this section for special rules
for certain variances and under or over-applied burdens).
(C) De minimis rule for certain direct material costs. A taxpayer
described in paragraph (d)(2)(iv)(A) of this section that uses the de
minimis rule described in this paragraph (d)(2)(iv)(C) includes in
additional section 263A costs, and excludes from section 471 costs, the
sum of the amounts of all of those uncapitalized direct material costs
that are incurred in the taxable year, if that sum is less than five
percent of total direct material costs incurred in the taxable year
(whether or not capitalized in the taxpayer's financial statement), or
another amount specified in other published guidance (see Sec.
601.601(d)(2) of this chapter). For purposes of determining the amount
of uncapitalized direct material costs for this five percent test, any
amounts that constitute a reduction to costs, such as cash and trade
discounts, are treated as a positive amount. The amounts of
uncapitalized direct material costs used for the five percent test, and
the amounts of uncapitalized direct material costs included in
additional section 263A costs under this paragraph (d)(2)(iv)(C), must
not include the types of costs included in the taxpayer's standard cost
method used for section 471 costs (but see paragraphs (d)(2)(v) and
(f)(3)(ii)(B) of this section for special rules for certain variances).
(D) Taxpayers using a historic absorption ratio. A taxpayer that
uses the historic absorption ratio provided in Sec. 1.263A-2(b)(4) or
(c)(4) or Sec. 1.263A-3(d)(4), and that uses a de minimis rule
described in paragraph (d)(2)(iv) of this section during its test
period or updated test period, determines whether direct labor costs or
direct material costs, as applicable, are included in any of its
section 471 costs remaining on hand at year end during its qualifying
period or extended qualifying period according to how those direct
labor costs or direct material costs, respectively, are identified in
at least two of the three years of the taxpayer's applicable test
period or updated test period. If a taxpayer described in this
paragraph (d)(2)(iv)(D) is required to revise any of its actual
absorption ratios for its test period or updated test period as a
result of a change in a method of accounting, the taxpayer determines
whether direct labor costs or direct material costs, as applicable, are
included in any of its section 471 costs on hand at year end during a
qualifying period or extended
[[Page 58489]]
qualifying period according to how those direct labor costs or direct
material costs, respectively, are identified in the taxpayer's revised
actual absorption ratios during its applicable test period or updated
test period.
(E) Examples. The following examples illustrate this paragraph
(d)(2)(iv):
(1) Example 1--Taxpayer using de minimis direct material costs
rule. Taxpayer R uses the modified simplified production method
described in Sec. 1.263A-2(c) and the de minimis method of
accounting under paragraph (d)(2)(iv)(C) of this section. In 2018, R
does not capitalize freight-in costs or trade discounts to property
produced or property acquired for resale in its financial statement
but does capitalize all other direct material costs to such property
in its financial statement. R incurs total direct material costs of
$3,105,000, which represents invoice price of $3,000,000 on goods
purchased, plus $120,000 of freight-in costs, less $15,000 for trade
discounts. For purposes of determining the amount of uncapitalized
direct material costs for the five percent test in paragraph
(d)(2)(iv)(C) of this section, R's trade discounts are treated as a
positive amount. Consequently, R's uncapitalized direct material
costs for purposes of the five percent test are $135,000 ($120,000
of freight-in plus $15,000 of trade discounts). Accordingly, under
paragraph (d)(2)(iv)(C) of this section, R's uncapitalized direct
material costs are 4.35% of total direct material costs ($135,000
divided by $3,105,000), and R includes a positive $120,000 of
freight-in and a negative $15,000 of trade discounts in its
additional section 263A costs and excludes those amounts from its
section 471 costs in the taxable year.
(2) Example 2--Taxpayer using de minimis direct labor costs rule
and historic absorption ratio. Taxpayer S uses the historic
absorption ratio provided in Sec. 1.263A-2(c)(4). S uses the de
minimis method of accounting under paragraph (d)(2)(iv)(B). S
excludes certain uncapitalized direct labor costs from its section
471 costs (and includes them in additional section 263A costs) under
paragraph (d)(2)(iv)(B) of this section in Years 1 and 3 of its
applicable test period. Because S excluded direct labor costs from
its section 471 costs in at least two of the three years of its
applicable test period, S must exclude those same costs from its
pre-production and production section 471 costs remaining on hand at
year end during its qualifying period or extended qualifying period.
(v) Safe harbor method for certain variances and under or over-
applied burdens--(A) In general. Notwithstanding paragraphs (d)(2)(i)
and (ii), (f)(3)(i)(C), and (f)(3)(ii)(B) of this section, a taxpayer
that uses the simplified resale method, the simplified production
method, or the modified simplified production method, may use the safe
harbor method described in this paragraph (d)(2)(v)(A) for all of its
variances and under or over-applied burdens that are not capitalized to
property produced or property acquired for resale in its financial
statement (uncapitalized variances and uncapitalized under or over-
applied burdens). A taxpayer using this safe harbor method must include
in additional section 263A costs, and exclude from section 471 costs,
the sum of the amounts of all of those uncapitalized variances and
uncapitalized under or over-applied burdens for the taxable year, if
that sum is less than five percent of the taxpayer's total section 471
costs for all items to which it allocates costs using a standard cost
method or burden rate method, or another percentage specified in other
published guidance (see Sec. 601.601(d)(2) of this chapter). If the
sum of uncapitalized variances and uncapitalized under or over-applied
burdens is not less than this five percent threshold, the taxpayer may
not exclude such uncapitalized variances and uncapitalized under or
over-applied burdens from section 471 costs, and must reallocate such
uncapitalized variances and uncapitalized under or over-applied burdens
to or among the units of property to which the costs are allocable in
accordance with paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of this
section (but see paragraph (d)(2)(v)(B) of this section for a rule that
a taxpayer using the safe harbor method described in this paragraph
(d)(2)(v)(A) may not use the methods of accounting described in
paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of this section to treat
certain uncapitalized variances and certain uncapitalized under or
over-applied burdens as not allocable to property). For purposes of
determining the amounts of uncapitalized variances and uncapitalized
under or over-applied burdens for this five percent test, all variances
and under or over-applied burdens are treated as positive amounts.
Additionally, for purposes of this five percent test, a taxpayer's
total section 471 costs for all items to which it allocates costs using
a standard cost method or burden rate method are determined before
application of the safe harbor method described in this paragraph
(d)(2)(v)(A), and therefore this amount must reflect the actual amounts
incurred by the taxpayer for those items during the taxable year, which
includes variances and under or over-applied burdens. The variances
described in this paragraph (d)(2)(v)(A) include any variances on cash
or trade discounts, if those discounts are capitalized as part of the
taxpayer's standard cost method used for section 471 costs.
(B) Consistency requirement. A taxpayer using the safe harbor
method described in paragraph (d)(2)(v)(A) of this section must use the
method consistently for all items to which it allocates costs using a
standard cost method or burden rate method and may not use the methods
of accounting described in paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B) of
this section to treat its uncapitalized variances and uncapitalized
under or over-applied burdens that are not significant in amount
relative to the taxpayer's total indirect costs incurred with respect
to production and resale activities for the year as not allocable to
property produced or property acquired for resale.
(C) Allocation of variances and under or over-applied burdens
between production and preproduction costs under the modified
simplified production method. In the case of a taxpayer using the
modified simplified production method and the safe harbor method
described in paragraph (d)(2)(v)(A) of this section, uncapitalized
variances and uncapitalized under or over-applied burdens treated as
additional section 263A costs under the safe harbor method must be
allocated between production additional section 263A costs, as
described in Sec. 1.263A-2(c)(3)(ii)(D)(1), and pre-production
additional section 263A costs, as described in Sec. 1.263A-
2(c)(3)(ii)(B)(1), using any reasonable method. In the case of a
taxpayer using the modified simplified production method and the safe
harbor method described in paragraph (d)(2)(v)(A) of this section,
uncapitalized variances and uncapitalized under or over-applied burdens
that are not excluded from section 471 costs must be allocated between
production section 471 costs, as described in Sec. 1.263A-
2(c)(3)(ii)(D)(3), and pre-production section 471 costs, as described
in Sec. 1.263A-2(c)(3)(ii)(B)(2) based on the taxpayer's reallocation
of such uncapitalized variances and uncapitalized under or over-applied
burdens to or among the units of property to which the costs are
allocable in accordance with paragraphs (f)(3)(i)(C) and (f)(3)(ii)(B)
of this section, as described in paragraph (d)(2)(v)(A) of this
section.
(D) Allocation of variances and under or over-applied burdens
between storage and handling costs absorption ratio and purchasing
costs absorption ratio under the simplified resale method. In the case
of a taxpayer using the simplified resale method, any uncapitalized
variances and uncapitalized under or over-applied
[[Page 58490]]
burdens treated as additional section 263A costs under the safe harbor
method described in paragraph (d)(2)(v)(A) of this section must be
allocated between storage and handling costs, as described in Sec.
1.263A-3(d)(3)(i)(D)(2), and current year's purchasing costs, as
described in Sec. 1.263A-3(d)(3)(i)(E)(2), using any reasonable
method.
(E) Method of accounting. The use of the safe harbor method
described in this paragraph (d)(2)(v) is the adoption of, or a change
in, a method of accounting under section 446 of the Internal Revenue
Code.
(vi) Removal of section 471 costs. A taxpayer must remove those
costs included in its section 471 costs that are not permitted to be
capitalized under either paragraph (c)(2) or (j)(2)(ii) of this section
and those costs included in its section 471 costs that are eligible for
capitalization under paragraph (j)(2) of this section that the taxpayer
does not elect to capitalize under section 263A. Except as otherwise
provided in paragraph (d)(3)(ii)(B) of this section, a taxpayer must
remove costs pursuant to this paragraph (d)(2)(vi) by adjusting its
section 471 costs and may not remove the costs by including a negative
adjustment in its additional section 263A costs. A taxpayer that
removes costs pursuant to this paragraph (d)(2)(vi) by adjusting its
section 471 costs must use a reasonable method that approximates the
manner in which the taxpayer originally capitalized the costs to its
property produced or property acquired for resale in its financial
statement.
(vii) Method changes. A taxpayer using the simplified production
method, simplified resale method, or the modified simplified production
method and that changes its financial statement practices for a cost in
a manner that would change its section 471 costs is required to change
its method of accounting for federal income tax purposes. A taxpayer
may change its method of accounting for determining section 471 costs
only with the consent of the Commissioner as required under section
446(e) and the corresponding regulations.
(3) Additional section 263A costs--(i) In general. Additional
section 263A costs are the costs, other than interest, that are not
included in a taxpayer's section 471 costs but that are required to be
capitalized under section 263A. Additional section 263A costs generally
do not include the direct costs that are required to be included in a
taxpayer's section 471 costs under paragraph (d)(2)(ii) of this
section; however, additional section 263A costs must include any direct
costs excluded from section 471 costs under paragraphs (d)(2)(iv) and
(v) of this section. For a taxpayer using the alternative method
described in paragraph (d)(2)(iii) of this section, additional section
263A costs must also include any negative or positive adjustments
required to be made as a result of differences in the book and tax
amounts of the taxpayer's section 471 costs.
(ii) Negative adjustments--(A) In general. Except as otherwise
provided by regulations or other published guidance (see Sec.
601.601(d)(2) of this chapter), a taxpayer may not include negative
adjustments in additional section 263A costs. However, for a taxpayer
using the alternative method described in paragraph (d)(2)(iii) of this
section, see paragraph (d)(2)(iii)(B) of this section for negative or
positive adjustments required to be made as a result of differences in
the book and tax amounts of the taxpayer's section 471 costs.
(B) Exception for certain taxpayers removing costs from section 471
costs. Notwithstanding paragraphs (d)(2)(vi) and (d)(3)(ii)(A) of this
section, and except as otherwise provided in paragraphs (d)(3)(ii)(C)
and (D) of this section, the following taxpayers may, but are not
required to, include negative adjustments in additional section 263A
costs to remove the taxpayer's section 471 costs that are described in
paragraph (d)(2)(vi) of this section (costs that are not required to
be, or are not permitted to be, capitalized under section 263A):
(1) A taxpayer using the simplified production method under Sec.
1.263A-2(b) if the taxpayer's (or its predecessor's) average annual
gross receipts for the three previous taxable years (test period) do
not exceed $50,000,000, or another amount specified in other published
guidance (see Sec. 601.601(d)(2) of this chapter). The rules of Sec.
1.263A-3(b) apply for purposes of determining the amount of a
taxpayer's gross receipts and the test period;
(2) A taxpayer using the modified simplified production method
under Sec. 1.263A-2(c); and
(3) A taxpayer using the simplified resale method under Sec.
1.263A-3(d).
(C) No negative adjustments for cash or trade discounts. A taxpayer
may not include negative adjustments in additional section 263A costs
for cash or trade discounts described in Sec. 1.471-3(b). However, see
paragraph (d)(2)(iv)(C) of this section for a de minimis rule for
certain direct material costs that may be included in additional
section 263A costs and paragraph (d)(2)(v) of this section for certain
variance amounts that may be included in additional section 263A costs.
(D) No negative adjustments for certain expenses. A taxpayer may
not include negative adjustments in additional section 263A costs for
an amount which is of a type for which a deduction would be disallowed
under section 162(c), (e), (f), or (g) and the regulations thereunder
in the case of a business expense.
(E) Consistency requirement for negative adjustments. A taxpayer
that is permitted to include negative adjustments in additional section
263A costs to remove section 471 costs under paragraph (d)(3)(ii)(B) of
this section and that includes negative adjustments to remove section
471 costs must use that method of accounting to remove all section 471
costs required to be removed under paragraph (d)(2)(vi) of this
section.
* * * * *
(5) Classification of costs. A taxpayer must classify section 471
costs, additional section 263A costs, and any permitted adjustments to
section 471 or additional section 263A costs, using the narrower of the
classifications of costs described in paragraphs (e)(2), (3), and (4)
of this section, whether or not the taxpayer is required to maintain
inventories, or the classifications of costs used by a taxpayer in its
financial statement. If a cost is not described in paragraph (e)(2),
(3), or (4) of this section, the cost is to be classified using the
classification of costs used in the taxpayer's financial statement.
(6) Financial statement. For purposes of section 263A, financial
statement means the taxpayer's financial statement listed in paragraphs
(d)(6)(i) through (iv) of this section that has the highest priority,
including within paragraphs (d)(6)(ii) and (iv) of this section. The
financial statements are, in descending priority:
(i) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(ii) A certified audited financial statement that is accompanied by
the report of an independent certified public accountant (or in the
case of a foreign entity, by the report of a similarly qualified
independent professional) that is used for:
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose;
(iii) A financial statement (other than a tax return) required to
be provided to
[[Page 58491]]
the federal or a state government or any federal or state agency (other
than the SEC or the Internal Revenue Service); or
(iv) A financial statement that is used for:
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose.
* * * * *
(f) * * *
(1) * * * In addition, in lieu of a facts-and-circumstances
allocation method, taxpayers may use the simplified methods provided in
Sec. Sec. 1.263A-2(b) and (c) and 1.263A-3(d) to allocate direct and
indirect costs to eligible property produced or eligible property
acquired for resale; see those sections for definitions of eligible
property.* * *
* * * * *
(h) * * *
(9) Separate election. A taxpayer may elect the simplified service
cost method in conjunction with any other allocation method used at the
trade or business level, including the simplified methods described in
Sec. Sec. 1.263A-2(b) and (c) and 1.263A-3(d). However, the election
of the simplified service cost method must be made independently of the
election to use those other simplified methods.
* * * * *
(l) * * *
(5) Definitions of section 471 costs and additional section 263A
costs. Paragraphs (d)(2) and (3) of this section apply for taxable
years beginning on or after November 20, 2018. For any taxable year
that both begins before November 20, 2018 and ends after November 20,
2018, the IRS will not challenge return positions consistent with all
of paragraphs (d)(2) and (3) of this section.
0
Par. 4. Section 1.263A-2 is amended by:
0
1. Revising paragraph (a)(5).
0
2. Designating the text of paragraph (b)(4)(v) as paragraph
(b)(4)(v)(A) and adding a paragraph heading.
0
3. Adding paragraph (b)(4)(v)(B).
0
4. Redesignating paragraphs (c), (d), (e), and (f) as paragraphs (d),
(e), (f), and (g).
0
5. Adding a new paragraph (c).
0
6. Adding paragraph (g)(3).
The revision and additions read as follows:
Sec. 1.263A-2 Rules relating to property produced by the taxpayer.
(a) * * *
(5) Taxpayers required to capitalize costs under this section. This
section generally applies to taxpayers that produce property. If a
taxpayer is engaged in both production activities and resale
activities, the taxpayer applies the principles of this section as if
it read production or resale activities, and by applying appropriate
principles from Sec. 1.263A-3. If a taxpayer is engaged in both
production and resale activities, the taxpayer may elect the simplified
production method or the modified simplified production method provided
in this section, but generally may not elect the simplified resale
method discussed in Sec. 1.263A-3(d). If elected, the simplified
production method or the modified simplified production method must be
applied to all eligible property produced and all eligible property
acquired for resale by the taxpayer.
(b) * * *
(4) * * *
(v) * * *
(A) Transition to elect historic absorption ratio. * * *
(B) Transition to revoke historic absorption ratio. Notwithstanding
the requirements provided in paragraph (b)(4)(iii)(B) of this section
regarding revocations of the historic absorption ratio during a
qualifying period, a taxpayer will be permitted to revoke the historic
absorption ratio in their first, second, or third taxable year ending
on or after November 20, 2018, under such administrative procedures and
with terms and conditions prescribed by the Commissioner.
* * * * *
(c) Modified simplified production method--(1) Introduction. This
paragraph (c) provides a simplified method for determining the
additional section 263A costs properly allocable to ending inventories
of property produced and other eligible property on hand at the end of
the taxable year.
(2) Eligible property--(i) In general. Except as otherwise provided
in paragraph (c)(2)(ii) of this section, the modified simplified
production method, if elected for any trade or business of a producer,
must be used for all production and resale activities associated with
any of the categories of property to which section 263A applies as
described in paragraph (b)(2)(i) of this section.
(ii) Election to exclude-self-constructed assets. A taxpayer using
the modified simplified production method may elect to exclude self-
constructed assets from application of the modified simplified
production method by following the same rules applicable to a taxpayer
using the simplified production method provided in paragraph (b)(2)(ii)
of this section.
(3) Modified simplified production method without historic
absorption ratio election--(i) General allocation formula--(A) In
general. Except as otherwise provided in paragraph (c)(3)(v) of this
section, the additional section 263A costs allocable to eligible
property remaining on hand at the close of the taxable year under the
modified simplified production method are computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.001
(B) Effect of allocation. The pre-production and production
absorption ratios generally are multiplied by the pre-production and
production section 471 costs, respectively, remaining in ending
inventory or otherwise on hand at the end of each taxable year in which
the modified simplified production method is applied. The sum of the
resulting products is the additional section 263A costs that are added
to the taxpayer's ending section 471 costs to determine the section
263A costs that are capitalized. See, however, paragraph (c)(3)(iv) of
this section for special rules applicable to LIFO taxpayers. Except as
otherwise provided in this section or in Sec. 1.263A-1 or Sec.
1.263A-3, additional section 263A costs that are allocated to
inventories on hand at the close of the taxable year under the modified
simplified production method of this paragraph (c) are treated as
inventory costs for all purposes of the Internal Revenue Code.
(ii) Definitions--(A) Direct material costs. For purposes of
paragraph (c) of this section, direct material costs has the same
meaning as described in Sec. 1.263A-1(e)(2)(i)(A). For purposes of
paragraph
[[Page 58492]]
(c) of this section, direct material costs include property produced
for the taxpayer under a contract with another party that are direct
material costs for the taxpayer to be used in an additional production
process of the taxpayer.
(B) Pre-production absorption ratio. Under the modified simplified
production method, the pre-production absorption ratio is determined as
follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.002
(1) Pre-production additional section 263A costs. Pre-production
additional section 263A costs are defined as the additional section
263A costs described in Sec. 1.263A-1(d)(3) that are pre-production
costs, as described in paragraph (a)(3)(ii) of this section, that a
taxpayer incurs during its current taxable year, including
capitalizable mixed service costs allocable to pre-production
additional section 263A costs, as described in paragraph (c)(3)(iii) of
this section, that a taxpayer incurs during its current taxable year:
(i) Plus additional section 263A costs properly allocable to
property acquired for resale that a taxpayer incurs during its current
taxable year; and
(ii) Plus additional section 263A costs properly allocable to
property produced for the taxpayer under a contract with another party
that is treated as property produced by the taxpayer, as described in
paragraph (a)(1)(ii)(B) of this section, that a taxpayer incurs during
its current taxable year.
(2) Pre-production section 471 costs. Pre-production section 471
costs are defined as the section 471 costs described in Sec. 1.263A-
1(d)(2) that are direct material costs that a taxpayer incurs during
its current taxable year plus the section 471 costs for property
acquired for resale (see Sec. 1.263A-1(e)(2)(ii)) that a taxpayer
incurs during its current taxable year, including property produced for
the taxpayer under a contract with another party that is acquired for
resale.
(C) Pre-production section 471 costs remaining on hand at year end.
Pre-production section 471 costs remaining on hand at year end means
the pre-production section 471 costs, as defined in paragraph
(c)(3)(ii)(B)(2) of this section, that a taxpayer incurs during its
current taxable year which remain in its ending inventory or are
otherwise on hand at year end, excluding the section 471 costs that are
direct material costs that have entered or completed production at year
end (for example, direct material costs in ending work-in-process
inventory and ending finished goods inventory). For LIFO inventories of
a taxpayer, see paragraph (c)(3)(iv) of this section.
(D) Production absorption ratio. Under the modified simplified
production method, the production absorption ratio is determined as
follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.003
(1) Production additional section 263A costs. Production additional
section 263A costs are defined as the additional section 263A costs
described in Sec. 1.263A-1(d)(3) that are not pre-production
additional section 263A costs, as defined in paragraph (c)(3)(ii)(B)(1)
of this section, that a taxpayer incurs during its current taxable
year, including capitalizable mixed service costs not allocable to pre-
production additional section 263A costs, as described in paragraph
(c)(3)(iii) of this section, that a taxpayer incurs during its current
taxable year. For example, production additional section 263A costs
include post-production costs, other than post-production costs
included in section 471 costs, as described in paragraph (a)(3)(iii) of
this section.
(2) Residual pre-production additional section 263A costs. Residual
pre-production additional section 263A costs are defined as the pre-
production additional section 263A costs, as defined in paragraph
(c)(3)(ii)(B)(1) of this section, that a taxpayer incurs during its
current taxable year less the product of the pre-production absorption
ratio, as determined in paragraph (c)(3)(ii)(B) of this section, and
the pre-production section 471 costs remaining on hand at year end, as
defined in paragraph (c)(3)(ii)(C) of this section.
(3) Production section 471 costs. Production section 471 costs are
defined as the section 471 costs described in Sec. 1.263A-1(d)(2) that
a taxpayer incurs during its current taxable year less pre-production
section 471 costs, as defined in paragraph (c)(3)(ii)(B)(2) of this
section, that a taxpayer incurs during its current taxable year.
(4) Direct materials adjustment. The direct materials adjustment is
defined as the section 471 costs that are direct material costs,
including property produced for a taxpayer under a contract with
another party that are direct material costs for the taxpayer to be
used in an additional production process of the taxpayer, that had not
entered production at the beginning of the current taxable year:
(i) Plus the section 471 costs that are direct material costs
incurred during the current taxable year (that is, direct material
purchases); and
(ii) Less the section 471 costs that are direct material costs that
have not entered production at the end of the current taxable year.
(E) Production section 471 costs remaining on hand at year end.
Production section 471 costs remaining on hand at year end means the
section 471 costs, as defined in Sec. 1.263A-1(d)(2), that a taxpayer
incurs during its current taxable year which remain in its ending
inventory or are otherwise on hand at year end, less the pre-production
section 471 costs remaining on hand at year end, as described in
paragraph (c)(3)(ii)(C) of this section. For LIFO inventories of a
taxpayer, see paragraph (c)(3)(iv) of this section.
(F) Costs allocated to property sold. The terms defined in
paragraph (c)(3)(ii) of this section do not include costs described in
Sec. 1.263A-1(e)(3)(ii) or cost reductions described in Sec. 1.471-
3(e) that a taxpayer properly allocates entirely to property that has
been sold.
(iii) Allocable mixed service costs--(A) In general. If a taxpayer
using the modified simplified production method determines its
capitalizable mixed service costs using a method described in Sec.
1.263A-1(g)(4), the taxpayer must use a reasonable method to allocate
the costs (for example, department or activity costs) between
production and
[[Page 58493]]
pre-production additional section 263A costs. If the taxpayer's Sec.
1.263A-1(g)(4) method allocates costs to a department or activity that
is exclusively identified as production or pre-production, those costs
must be allocated to production or pre-production additional section
263A costs, respectively.
(B) Taxpayer using the simplified service cost method. If a
taxpayer using the modified simplified production method determines its
capitalizable mixed service costs using the simplified service cost
method described in Sec. 1.263A-1(h), the amount of capitalizable
mixed service costs, as computed using the general allocation formula
in Sec. 1.263A-1(h)(3)(i), allocated to and included in pre-production
additional section 263A costs in the absorption ratio described in
paragraph (c)(3)(ii)(B) of this section is determined based on either
of the following: The proportion of direct material costs to total
section 471 costs that a taxpayer incurs during its current taxable
year or the proportion of pre-production labor costs to total labor
costs that a taxpayer incurs during its current taxable year. The
taxpayer must include the capitalizable mixed service costs that are
not allocated to pre-production additional section 263A costs in
production additional section 263A costs in the absorption ratio
described in paragraph (c)(3)(ii)(D) of this section. A taxpayer that
allocates capitalizable mixed service costs based on labor under this
paragraph (c)(3)(iii)(B) must exclude mixed service labor costs from
both pre-production labor costs and total labor costs.
(C) De minimis rule. Notwithstanding paragraphs (c)(3)(iii)(A) and
(B) of this section, if 90 percent or more of a taxpayer's
capitalizable mixed service costs determined under paragraph
(c)(3)(iii)(A) or (B) of this section are allocated to pre-production
additional section 263A costs or production additional section 263A
costs, the taxpayer may elect to allocate 100 percent of its
capitalizable mixed service costs to that amount. For example, if 90
percent of capitalizable mixed service costs are allocated to
production additional section 263A costs based on the labor costs that
are pre-production costs in total labor costs incurred in the
taxpayer's trade or business during the taxable year, then 100 percent
of capitalizable mixed service costs may be allocated to production
additional section 263A costs. An election to allocate capitalizable
mixed service costs under this paragraph (c)(3)(iii)(C) is the adoption
of, or a change in, a method of accounting under section 446 of the
Internal Revenue Code.
(iv) LIFO taxpayers electing the modified simplified production
method--(A) In general. Under the modified simplified production
method, a taxpayer using a LIFO method must calculate a particular
year's index (for example, under Sec. 1.472-8(e)) without regard to
its additional section 263A costs. Similarly, a taxpayer that adjusts
current-year costs by applicable indexes to determine whether there has
been an inventory increment or decrement in the current year for a
particular LIFO pool must disregard the additional section 263A costs
in making that determination.
(B) LIFO increment--(1) In general. If the taxpayer determines
there has been an inventory increment, the taxpayer must state the
amount of the increment in terms of section 471 costs in current-year
dollars. The taxpayer then multiplies this amount by the combined
absorption ratio, as defined in paragraph (c)(3)(iv)(B)(2) of this
section. The resulting product is the additional section 263A costs
that must be added to the taxpayer's increment in terms of section 471
costs in current-year dollars for the taxable year.
(2) Combined absorption ratio defined. For purposes of paragraph
(c)(3)(iv)(B)(1) of this section, the combined absorption ratio is the
additional section 263A costs allocable to eligible property remaining
on hand at the close of the taxable year, as described in paragraph
(c)(3)(i)(A) of this section, determined on a non-LIFO basis, divided
by the pre-production and production section 471 costs remaining on
hand at year end, determined on a non-LIFO basis.
(C) LIFO decrement. If the taxpayer determines there has been an
inventory decrement, the taxpayer must state the amount of the
decrement in dollars applicable to the particular year for which the
LIFO layer has been invaded. The additional section 263A costs incurred
in prior years that are applicable to the decrement are charged to cost
of goods sold. The additional section 263A costs that are applicable to
the decrement are determined by multiplying the additional section 263A
costs allocated to the layer of the pool in which the decrement
occurred by the ratio of the decrement, excluding additional section
263A costs, to the section 471 costs in the layer of that pool.
(v) De minimis rule for producers with total indirect costs of
$200,000 or less. Paragraph (b)(3)(iv) of this section, which provides
that the additional section 263A costs allocable to eligible property
remaining on hand at the close of the taxable year are deemed to be
zero for producers with total indirect costs of $200,000 or less,
applies to the modified simplified production method.
(vi) Examples. The provisions of this paragraph (c) are illustrated
by the following examples:
(A) Example 1--FIFO inventory method. (1) Taxpayer P uses the
FIFO method of accounting for inventories valued at cost. P's
beginning inventory for 2018 (all of which is sold during 2018) is
$2,500,000, consisting of $500,000 of pre-production section 471
costs (including $400,000 of direct material costs and $100,000 of
property acquired for resale), $1,500,000 of production section 471
costs, and $500,000 of additional section 263A costs. During 2018, P
incurs $2,500,000 of pre-production section 471 costs (including
$1,900,000 of direct material costs and $600,000 of property
acquired for resale), $7,500,000 of production section 471 costs,
$200,000 of pre-production additional section 263A costs, and
$800,000 of production additional section 263A costs. P's additional
section 263A costs include capitalizable mixed service costs under
the simplified service cost method. P's pre-production and
production section 471 costs remaining in ending inventory at the
end of 2018 are $1,000,000 (including $800,000 of direct material
costs and $200,000 of property acquired for resale) and $2,000,000,
respectively. P computes its pre-production absorption ratio for
2018 under paragraph (c)(3)(ii)(B) of this section, as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.004
(2) Under paragraph (c)(3)(ii)(D)(2) of this section, P's
residual pre-production additional section 263A costs for 2018 are
$120,000 ($200,000 of pre-production additional section 263A costs
less $80,000 (the product of the 8% pre-production
[[Page 58494]]
absorption ratio and the $1,000,000 of pre-production section 471
costs remaining on hand at year end)).
(3) Under paragraph (c)(3)(ii)(D)(4) of this section, P's direct
materials adjustment for 2018 is $1,500,000 ($400,000 of direct
material costs in beginning raw materials inventory, plus $1,900,000
of direct material costs incurred to acquire raw materials during
the taxable year, less $800,000 direct material costs in ending raw
materials inventory).
(4) P computes its production absorption ratio for 2018 under
paragraph (c)(3)(ii)(D) of this section, as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.005
(5) Under the modified simplified production method, P
determines the additional section 263A costs allocable to its ending
inventory under paragraph (c)(3)(i)(A) of this section by
multiplying the pre-production absorption ratio by the pre-
production section 471 costs remaining on hand at year end and the
production absorption ratio by the production section 471 costs
remaining on hand at year end, as follows:
Additional section 263A costs = (8% x $1,000,000) + (10.22% x
$2,000,000) = $284,400
(6) P adds this $284,400 to the $3,000,000 of section 471 costs
remaining on hand at year end to calculate its total ending
inventory of $3,284,400. The balance of P's additional section 263A
costs incurred during 2018, $715,600 ($1,000,000 less $284,400), is
taken into account in 2018 as part of P's cost of goods sold.
(7) P's computation is summarized in the following table:
------------------------------------------------------------------------
Reference Amount
------------------------------------------------------------------------
Beginning Inventory:
Direct material costs......... a................... $ 400,000
Property acquired for resale.. b................... 100,000
---------------
Pre-production section 471 c = a + b........... 500,000
costs.
Production section 471 costs.. d................... 1,500,000
Additional section 263A costs. e................... 500,000
---------------
Total..................... f = c d + e......... 2,500,000
Incurred During 2018:
Direct material costs......... g................... 1,900,000
Property acquired for resale.. h................... 600,000
---------------
Pre-production section 471 i = g + h........... 2,500,000
costs.
Production section 471 costs.. j................... 7,500,000
Pre-production additional k................... 200,000
section 263A costs.
Production additional section l................... 800,000
263A costs.
---------------
Total..................... m = i + j + k + l... 11,000,000
Ending Inventory:
Direct material costs......... n................... 800,000
Property acquired for resale.. o................... 200,000
---------------
Pre-production section 471 p = n + o........... 1,000,000
costs.
Production section 471 costs.. q................... 2,000,000
---------------
Section 471 costs............. r = p + q........... 3,000,000
Additional section 263A costs s = v + z........... 284,400
allocable to ending inventory.
---------------
Total..................... t = r + s........... 3,284,400
Modified Simplified Production
Method:
Pre-production additional k................... 200,000
section 263A costs.
Pre-production section 471 i................... 2,500,000
costs.
Pre-production absorption u = k / i........... 8.00%
ratio.
Pre-production section 471 p................... 1,000,000
costs remaining on hand at
year end.
Pre-production additional v = u * p........... 80,000
section 263A costs allocable
to ending inventory.
Production additional section l................... 800,000
263A costs.
Residual pre-production w = k-(u * p)....... 120,000
additional section 263A costs.
Production section 471 costs.. j................... 7,500,000
Direct materials adjustment... x = a + g-n......... 1,500,000
Production absorption ratio... y = (l + w) / (j + 10.22%
x).
Production section 471 costs q................... 2,000,000
remaining on hand at year end.
Production additional section z = y * q........... 204,400
263A costs allocable to
ending inventory.
Summary:
Pre-production additional v................... 80,000
section 263A costs allocable
to ending inventory.
Production additional section z................... 204,400
263A costs allocable to
ending inventory.
---------------
Additional section 263A costs s................... 284,400
allocable to ending inventory.
Section 471 costs............. r................... 3,000,000
---------------
[[Page 58495]]
Total Ending Inventory.... t................... 3,284,400
------------------------------------------------------------------------
(B) Example 2--FIFO inventory method with alternative method to
determine amounts of section 471 costs. (1) The facts are the same
as in Example 1 of paragraph (c)(3)(vi)(A) of this section, except
that P uses the alternative method to determine amounts of section
471 costs by using its financial statement under Sec. 1.263A-
1(d)(2)(iii) rather than tax amounts under Sec. 1.263A-1(d)(2)(i).
In 2018, P's production section 471 costs exclude $40,000 of tax
depreciation in excess of financial statement depreciation and
include $50,000 of financial statement direct labor in excess of tax
direct labor. These are P's only differences in its book and tax
amounts.
(2) Under Sec. 1.263A-1(d)(2)(iii)(B), the positive $40,000
depreciation adjustment and the negative $50,000 direct labor
adjustment must be included in additional section 263A costs.
Accordingly, P's production additional section 263A costs are
$790,000 ($800,000 plus $40,000 less $50,000).
(3) P computes its production absorption ratio for 2018 under
paragraph (c)(3)(ii)(D) of this section, as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.006
(4) Under the modified simplified production method, P
determines the additional section 263A costs allocable to its ending
inventory under paragraph (c)(3)(i)(A) of this section by
multiplying the pre-production absorption ratio by the pre-
production section 471 costs remaining on hand at year end and the
production absorption ratio by the production section 471 costs
remaining on hand at year end, as follows:
Additional section 263A costs = (8.00% x $1,000,000) + (10.11% x
$2,000,000) = $282,200
(5) P adds this $282,200 to the $3,000,000 of section 471 costs
remaining on hand at year end to calculate its total ending
inventory of $3,282,200. The balance of P's additional section 263A
costs incurred during 2018, $717,800 ($1,000,000 less $282,200), is
taken into account in 2018 as part of P's cost of goods sold.
(C) Example 3--LIFO inventory method. (1) The facts are the same
as in Example 1 of paragraph (c)(3)(vi)(A) of this section, except
that P uses a dollar-value LIFO inventory method rather than the
FIFO method. P's 2018 LIFO increment is $1,500,000.
(2) Under paragraph (c)(3)(iv)(B)(1) of this section, to
determine the additional section 263A costs allocable to its ending
inventory, P multiplies the combined absorption ratio by the
$1,500,000 of LIFO increment. Under paragraph (c)(3)(iv)(B)(2) of
this section, the combined absorption ratio is 9.48% ($284,400
additional section 263A costs allocable to ending inventory,
determined on a non-LIFO basis, divided by $3,000,000 of section 471
costs on hand at year end, determined on a non-LIFO basis). Thus,
P's additional section 263A costs allocable to its ending inventory
are $142,200 ($1,500,000 multiplied by 9.48%). This $142,200 is
added to the $1,500,000 to determine a total 2018 LIFO increment of
$1,642,200. The balance of P's additional section 263A costs
incurred during 2018, $857,800 ($1,000,000 less $142,200), is taken
into account in 2018 as part of P's cost of goods sold.
(3) In 2019, P sells one-half of the inventory in its 2018
increment. P must include in its cost of goods sold for 2019 the
amount of additional section 263A costs relating to this inventory,
$71,100 (one-half of the $142,200 additional section 263A costs
capitalized in 2018 ending inventory).
(D) Example 4--Direct materials-based allocation of mixed
service costs. (1) Taxpayer R computes its capitalizable mixed
service costs using the simplified service cost method described in
Sec. 1.263A-1(h). During 2018, R incurs $200,000 of capitalizable
mixed service costs, computed using the general allocation formula
in Sec. 1.263A-1(h). During 2018, R also incurs $8,000,000 of total
section 471 costs, including $2,000,000 of direct material costs.
(2) Under paragraph (c)(3)(iii)(B) of this section, R determines
its capitalizable mixed service costs allocable to pre-production
additional section 263A costs based on the proportion of direct
material costs in total section 471 costs. R's direct material costs
are 25% of total section 471 costs ($2,000,000 of direct material
costs incurred during the year divided by $8,000,000 of total
section 471 costs incurred during the year). Thus, R allocates
$50,000 (25% x $200,000) of mixed service costs to pre-production
additional section 263A costs. R includes the remaining $150,000
($200,000 less $50,000) of capitalizable mixed service costs as
production additional section 263A costs.
(E) Example 5--Labor-based allocation of mixed service costs.
(1) Taxpayer S computes its capitalizable mixed service costs using
the simplified service cost method described in Sec. 1.263A-1(h).
During 2018, S incurs $200,000 of capitalizable mixed service costs,
computed using the general allocation formula in Sec. 1.263A-1(h).
During 2018, S also incurs $10,000,000 of total labor costs
(excluding any labor costs included in mixed service costs),
including $1,000,000 of labor costs that are pre-production costs as
described in paragraph (a)(3)(ii) of this section (excluding any
labor costs included in mixed service costs).
(2) Under paragraph (c)(3)(iii)(B) of this section, S determines
its capitalizable mixed service costs allocable to pre-production
additional section 263A costs based on the proportion of labor costs
that are pre-production costs in labor costs. S's pre-production
labor costs are 10% of labor costs ($1,000,000 of labor costs
incurred during the year that are pre-production costs (excluding
any labor costs included in mixed service costs), divided by
$10,000,000 of total labor costs incurred during the year (excluding
any labor costs included in mixed service costs). Thus, S allocates
$20,000 (10% x $200,000) of mixed service costs to pre-production
additional section 263A costs. S includes the remaining $180,000
($200,000 less $20,000) of capitalizable mixed service costs as
production additional section 263A costs.
(F) Example 6--De minimis rule for allocation of mixed service
costs. The facts are the same as in Example 5 in paragraph
(c)(3)(vi)(E) of this section, except that S uses the de minimis
rule for mixed service costs in paragraph (c)(3)(iii)(C) of this
section. Because 90% or more of S's capitalizable mixed service
costs are allocated to production additional section 263A costs,
under the de minimis rule, S allocates all $200,000 of capitalizable
mixed service costs to production additional section 263A costs.
None of the capitalizable mixed service costs are allocated to pre-
production additional section 263A costs.
(4) Modified simplified production method with historic absorption
ratio election--(i) In general. This paragraph (c)(4) generally permits
taxpayers using the modified simplified production method to elect a
historic absorption ratio in determining additional section 263A costs
allocable to eligible property remaining on hand at the close of their
taxable years. A taxpayer may only make a historic absorption ratio
election under this paragraph (c)(4) if it has used the modified
simplified production method for three or more consecutive taxable
years immediately prior to the year of election and has capitalized
additional section 263A costs using an actual pre-production absorption
ratio, as defined in paragraph (c)(3)(ii)(B) of this section, and an
actual production absorption ratio, as defined in paragraph
[[Page 58496]]
(c)(3)(ii)(D) of this section, or an actual combined absorption ratio,
as defined in paragraph (c)(3)(iv)(B)(2) of this section, for its three
most recent consecutive taxable years. This method is not available to
a taxpayer that is deemed to have zero additional section 263A costs
under paragraph (c)(3)(v) of this section. The historic absorption
ratio is used in lieu of the actual absorption ratios computed under
paragraph (c)(3)(ii) of this section or the actual combined absorption
ratio computed under paragraph (c)(3)(iv) and is based on costs
capitalized by a taxpayer during its test period. If elected, the
historic absorption ratio must be used for each taxable year within the
qualifying period described in paragraph (b)(4)(ii)(C) of this section.
Except as otherwise provided in this paragraph (c)(4), paragraph (b)(4)
of this section applies to the historic absorption ratio election under
the modified simplified production method.
(ii) Operating rules and definitions--(A) Pre-production historic
absorption ratio. The pre-production historic absorption ratio is
computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.007
(1) Pre-production additional section 263A costs incurred during
the test period are defined as the pre-production additional section
263A costs described in paragraph (c)(3)(ii)(B)(1) of this section that
the taxpayer incurs during the test period described in paragraph
(b)(4)(ii)(B) of this section.
(2) Pre-production section 471 costs incurred during the test
period are defined as the pre-production section 471 costs described in
paragraph (c)(3)(ii)(B)(2) of this section that the taxpayer incurs
during the test period described in paragraph (b)(4)(ii)(B) of this
section.
(B) Production historic absorption ratio. The production historic
absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.008
(1) Production additional section 263A costs incurred during the
test period are defined as the production additional section 263A costs
described in paragraph (c)(3)(ii)(D)(1) of this section that the
taxpayer incurs during the test period described in paragraph
(b)(4)(ii)(B) of this section.
(2) Residual pre-production additional section 263A costs incurred
during the test period are defined as the residual pre-production
additional section 263A costs described in paragraph (c)(3)(ii)(D)(2)
of this section that the taxpayer incurs during the test period
described in paragraph (b)(4)(ii)(B) of this section.
(3) Production section 471 costs incurred during the test period
are defined as the production section 471 costs described in paragraph
(c)(3)(ii)(D)(3) of this section that the taxpayer incurs during the
test period described in paragraph (b)(4)(ii)(B) of this section.
(4) Direct materials adjustments made during the test period are
defined as the direct materials adjustments described in paragraph
(c)(3)(ii)(D)(4) of this section that the taxpayer incurs during the
test period described in paragraph (b)(4)(ii)(B) of this section.
(iii) LIFO taxpayers making the historic absorption ratio
election--(A) In general. Instead of the pre-production and production
historic absorption ratios defined in paragraph (c)(4)(ii) of this
section, a LIFO taxpayer making the historic absorption ratio election
under the modified simplified production method calculates a combined
historic absorption ratio based on costs the taxpayer capitalizes
during its test period.
(B) Combined historic absorption ratio. The combined historic
absorption ratio is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.009
(1) Total allocable additional section 263A costs incurred during
the test period. Total allocable additional section 263A costs incurred
during the test period are the sum of the total additional section 263A
costs allocable to eligible property on hand at year end as described
in paragraph (c)(3)(i)(A) of this section, determined on a non-LIFO
basis, for all taxable years in the test period.
(2) Total section 471 costs remaining on hand at each year end of
the test period. Total section 471 costs remaining on hand at each year
end of the test period are the sum of the total pre-production section
471 costs remaining on hand at year end as described in paragraph
(c)(3)(ii)(C) of this section and the total production section 471
costs remaining on hand at year end as described in paragraph
(c)(3)(ii)(E) of this section, determined on a non-LIFO basis, for all
taxable years in the test period.
(iv) Extension of qualifying period. In the first taxable year
following the close of each qualifying period (for example, the sixth
taxable year following the test period), a taxpayer must compute the
actual absorption ratios under paragraph (c)(3) of this section (pre-
production and production absorption ratios or, for LIFO taxpayers, the
combined absorption ratio). If the actual combined absorption ratio or
both the actual pre-production and production absorption ratios, as
applicable, computed for this
[[Page 58497]]
taxable year (the recomputation year) is within one-half of one
percentage point, plus or minus, of the corresponding historic
absorption ratio or ratios used in determining capitalizable costs for
the qualifying period (the previous five taxable years), the qualifying
period is extended to include the recomputation year and the following
five taxable years, and the taxpayer must continue to use the historic
absorption ratio or ratios throughout the extended qualifying period.
If, however, the actual combined historic absorption ratio or either
the actual pre-production absorption ratio or production absorption
ratio, as applicable, is not within one-half of one percentage point,
plus or minus, of the corresponding historic absorption ratio, the
taxpayer must use the actual combined absorption ratio or ratios
beginning with the recomputation year and throughout the updated test
period. The taxpayer must resume using the historic absorption ratio or
ratios based on the updated test period in the third taxable year
following the recomputation year.
(v) Examples. The provisions of this paragraph (c)(4) are
illustrated by the following examples:
(A) Example 1--HAR and FIFO inventory method. (1) Taxpayer S
uses the FIFO method of accounting for inventories valued at cost
and for 2021 elects to use the historic absorption ratio with the
modified simplified production method. S identifies the following
costs incurred during the test period:
----------------------------------------------------------------------------------------------------------------
2018 2019 2020
----------------------------------------------------------------------------------------------------------------
Pre-production additional section 263A costs.................... $100 $200 $300
Production additional section 263A costs........................ 200 350 450
Pre-production section 471 costs................................ 2,000 2,500 3,000
Production section 471 costs.................................... 2,500 3,500 4,000
Residual pre-production additional section 263A costs........... 60 136 220
Direct materials adjustments.................................... 2,700 3,200 3,700
----------------------------------------------------------------------------------------------------------------
(2) Under paragraph (c)(4)(ii)(A) of this section, S computes
the pre-production historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.010
(3) Under paragraph (c)(4)(ii)(B) of this section, S computes
the production historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.011
(4) In 2021, S incurs $10,000 of section 471 costs of which
$1,000 pre-production section 471 costs and $2,000 production 471
costs remain in ending inventory. Under the modified simplified
production method using a historic absorption ratio, S determines
the pre-production additional section 263A costs allocable to its
ending inventory by multiplying its pre-production historic
absorption ratio (8.00%) by the pre-production section 471 costs
remaining on hand at year end ($1,000). Thus, S allocates $80 of
pre-production additional section 263A costs to its ending inventory
(8.00% x $1,000). S determines the production additional section
263A costs allocable to its ending inventory by multiplying its
production historic absorption ratio (7.22%) by the production
section 471 costs remaining on hand at year end ($2,000). Thus, S
allocates $144 of production additional section 263A costs to its
ending inventory (7.22% x $2,000).
(5) Under paragraph (c)(4)(i) of this section, S's total
additional section 263A costs allocable to ending inventory in 2021
are $224, which is the sum of the allocable pre-production
additional section 263A costs ($80) and the allocable production
additional section 263A costs ($144). S's ending inventory in 2021
is $3,224, which is the sum of S's additional section 263A costs
allocable to ending inventory and S's section 471 costs remaining in
ending inventory ($224 + $3,000). The balance of S's additional
section 263A costs incurred during 2021 is taken into account in
2021 as part of S's cost of goods sold.
(B) Example 2--HAR and LIFO inventory method. (1)(i) The facts
are the same as in Example 1 in paragraph (c)(4)(v)(A) of this
section, except that S uses a dollar-value
[[Page 58498]]
LIFO inventory method rather than the FIFO method. S calculates
additional section 263A costs incurred during the taxable year and
allocable to ending inventory under paragraph (c)(4)(iii) of this
section and identifies the following costs incurred during the test
period:
----------------------------------------------------------------------------------------------------------------
2018 2019 2020
----------------------------------------------------------------------------------------------------------------
Additional section 263A costs incurred during the taxable year $90 $137 $167
allocable to ending inventory..................................
Section 471 costs incurred during the taxable year that remain 1,000 1,400 2,100
in ending inventory............................................
----------------------------------------------------------------------------------------------------------------
(ii) In 2021, the LIFO value of S's increment is $1,500.
(2) Under paragraph (c)(4)(iii) of this section, S computes a
combined historic absorption ratio as follows:
[GRAPHIC] [TIFF OMITTED] TR20NO18.012
(3) S's additional section 263A costs allocable to its 2021
LIFO increment are $131 ($1,500 beginning LIFO increment x 8.76%
combined historic absorption ratio). S adds the $131 to the $1,500
LIFO increment to determine a total 2021 LIFO increment of $1,631.
* * * * *
(g) * * *
(3) Paragraph (c) of this section applies for taxable years
beginning on or after November 20, 2018. For any taxable year that both
begins before November 20, 2018 and ends after November 20, 2018, the
IRS will not challenge return positions consistent with all of
paragraphs (c) of this section.
0
Par. 5. Section 1.263A-3 is amended by:
0
1. Revising paragraph (a)(4)(i).
0
2. Designating the text of paragraph (d)(4)(v) as paragraph
(d)(4)(v)(A) and adding a paragraph heading.
0
3. Adding paragraph (d)(4)(v)(B).
The revision and additions read as follows:
Sec. 1.263A-3 Rules relating to property acquired for resale.
(a) * * *
(4) * * *
(i) In general. Except as provided in paragraphs (a)(4)(ii) and
(iii) of this section, a taxpayer may elect the simplified production
method, as described in Sec. 1.263A-2(b), or the modified simplified
production method, as described in Sec. 1.263A-2(c), but may not elect
the simplified resale method, as described in paragraph (d) of this
section, if the taxpayer is engaged in both production and resale
activities with respect to the items of eligible property listed in
Sec. 1.263A-2(b)(2).
* * * * *
(d) * * *
(4) * * *
(v) * * *
(A) Transition to elect historic absorption ratio. * * *
(B) Transition to revoke historic absorption ratio. Notwithstanding
the requirements provided in paragraph (d)(4)(iii)(B) of this section
regarding revocations of the historic absorption ratio during a
qualifying period, a taxpayer will be permitted to revoke the historic
absorption ratio in their first, second, or third taxable year ending
on or after November 20, 2018, under such administrative procedures and
with terms and conditions prescribed by the Commissioner.
* * * * *
0
Par. 6. In Sec. 1.263A-7, paragraph (b)(2)(iii)(A)(2)(ii) is revised
to read as follows:
Sec. 1.263A-7 Changing a method of accounting under section 263A.
* * * * *
(b) * * *
(2) * * *
(iii) * * *
(A) * * *
(2) * * *
(ii) Simplified method used. A dollar-value LIFO taxpayer using the
3-year average method and the simplified production method, the
modified simplified production method, or the simplified resale method
to revalue its inventory is permitted, but not required, to establish a
new base year.
* * * * *
0
Par. 7. In Sec. 1.471-3, paragraph (b) is revised to read as follows:
Sec. 1.471-3 Inventories at cost.
* * * * *
(b) In the case of merchandise purchased since the beginning of the
taxable year, the invoice price less trade or other discounts, except
strictly cash discounts approximating a fair interest rate, which may
be deducted or not at the option of the taxpayer, provided a consistent
course is followed. To this net invoice price should be added
transportation or other necessary charges incurred in acquiring
possession of the goods. But see Sec. 1.263A-1(d)(2)(iv)(C) for
special rules for certain direct material costs that in certain cases
are permitted to be capitalized as additional section 263A costs by
taxpayers using a simplified method under Sec. 1.263A-2(b) or (c) or
Sec. 1.263A-3(d). For taxpayers acquiring merchandise for resale that
are subject to the provisions of section 263A, see Sec. Sec. 1.263A-1
and 1.263A-3 for additional amounts that must be included in inventory
costs.
* * * * *
Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.
Approved: July 23, 2018.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
Note: This document was received for publication by the Office
of the Federal Register on November 6, 2018.
[FR Doc. 2018-24545 Filed 11-19-18; 8:45 am]
BILLING CODE 4830-01-P